I have good reasons for shying away from these types of loans.
I’ve had numerous mortgage loans over the years. These include both fixed-rate and adjustable-rate mortgages as well as 30-year and 15-year loans. I’ve bought and sold houses and refinanced my existing mortgage debt.
But there are a few home loans I would never take out. Here are three — along with some very valid reasons why I’d avoid them.
1. Balloon mortgage
Balloon mortgages work in slightly different ways, but they all have one thing in common: A large lump-sum payment is due after a short period of time.
With a balloon mortgage, you’ll normally make payments for a limited time, such as five or seven years. You’ll then owe the entire remaining balance of your mortgage loan — which often means a payment of hundreds of thousands of dollars.
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Some balloon mortgages don’t charge monthly payments at all (although those are usually very-short term loans). With others, the monthly payment is normally based on what you’d owe if you were paying your loan over a longer period. But there will always be a lump-sum payment.
Many borrowers take out balloon mortgages because they offer lower interest rates or provide other advantages, such as reduced monthly payments. Usually, the goal is to refinance before the lump-sum payment is due. But refinancing isn’t always possible. And if you can’t refinance or pay off your entire loan, you could face foreclosure.
This risk is way too big. This is why I’d never consider a balloon mortgage — and you may want to think carefully about it too.
2. An interest-only mortgage
Interest-only mortgages involve repaying only interest and no principal. This results in a lower monthly payment. The problem is that you don’t make any progress with loan paydown. You send interest to your mortgage lender every month without acquiring any equity in your home.
Of course, you’ll have to start paying down your loan eventually, or you’d be in debt forever. There are a few ways this could happen.
Your loan may be structured as a balloon loan. As we saw above, this would mean you’d pay interest only for a few years and then owe a big lump sum. Or you may have a limited interest-only period such as five or seven years. After that, you’d start to pay both principal and interest. Those payments would be higher than if you’d been paying principal and interest from the start.
This type of loan also carries a lot of risk. You may struggle to afford your higher monthly payments or balloon payment later. And since you aren’t building equity, you could be in trouble if property values decline. You may end up owing more than your home is worth (also known as being underwater on your loan).
I don’t want to make it more difficult to pay off my mortgage, so I’d be unwilling to take an interest-only loan.
3. A 40-year fixed-rate loan
A 40-year fixed-rate loan is very similar to a 30-year or 20-year fixed-rate loan. The difference is that the loan repayment timeline is 10 years longer.
This lowers the monthly payments. But it also adds to your total interest costs. And it’ll take another decade before you’ll be debt free. These added costs and the fact that you have an ongoing mortgage obligation for 40 years are off-putting.
There’s a bigger chance you’ll carry your loan into retirement. This would also mean you’d need to save more money for your later years. It also reduces 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 so many extra years.
Instead of these unusual — and risky — loans, I believe it’s best to stick to a standard 15-year, 20-year, or 30-year fixed-rate loan. There’s a good chance that’s the right choice for most borrowers too.