Alternatives to the Traditional Mortgage

You've found your dream home. Now, how exactly do you plan to pay for it? These days, financing a home goes way beyond the conventional fixed-rate loan. Buyers can enjoy lower interest rates, reduced payments and greater flexibility -- but do those rewards outweigh the potential risks? Find out if these alternative mortgages would work for you.

Pay-Option ARM

WHAT’S GOOD: Most buyers are familiar with standard adjustable-rate mortgages -- you lock in at a low rate for a few years, after which your interest rate will be adjusted according to the market. If the interest rate skyrockets, your monthly payments will follow suit. But in a pay-option ARM, borrowers can opt for a fixed monthly payment that won’t fluctuate with their interest rate. 

WHAT’S BAD: You could end up losing equity, thanks to a potential pitfall called negative amortization. When your interest rate increases, your monthly payment might suddenly be lower than the interest due -- and the difference gets tacked on to your outstanding balance. Unless you plan to move or refinance before the introductory term is up, consider a more stable loan.

Interest-Only Mortgage

WHAT’S GOOD: For the first 10 years of your loan, you only pay the interest accrued. After the introductory phase is over, the balance is amortized over the remaining term of the loan. This reduces the monthly payment during the first decade, allowing the buyer to purchase a home while they’re still building their financial foothold. 

WHAT’S BAD: After 10 years, your loan balance will have decreased by...zero dollars. (This lack of equity also makes it a risky investment for lenders, so the interest rate may be higher as a result.) Unless you’re in a job with guaranteed growth potential -- or you absolutely plan to stay for more than 10 years -- you may be better off with a loan that chips away at the principal.

Balloon Mortgage

WHAT’S GOOD: During the introductory period, typically five to seven years, borrowers pay a low monthly payment. At the end of the term, the remaining principal is paid off in a lump sum. 

WHAT’S BAD: If you can’t pay the balloon payment, you’ll have to refinance -- meaning a second round of closing costs and the risk of a higher interest rate. Borrowers who don’t qualify for a refi could even face foreclosure.

Lease-To-Own

WHAT’S GOOD: Instead of purchasing the home outright, the buyer rents the house temporarily while the seller puts a portion of the monthly rent into an escrow account. When the lease is up, the buyer can use the escrow account toward a down payment -- or just pack up and move on. Read The Facts on Lease-to-Buy.

WHAT’S BAD: Actually, the seller assumes most of the risk in this agreement, since the buyer has the option to walk away. However, both parties may want to hire a real estate attorney who can deal with any snags.

Cash-Out Mortgage

WHAT’S GOOD: Homeowners who have already built up some equity can refinance their home and walk away with cold, hard cash -- which can be used to bankroll home improvement projects, college-bound kids, or an investment property. 

WHAT’S BAD: It’s a risky proposition. If housing prices plummet, you could end up “underwater,” lender-speak for owing more than your home is worth. If the housing bubble already has you chewing your nails, you may want to look for a loan that isn’t secured against your house.

Still unsure? Talk to an advisor who can help you determine which mortgage options are the best fit for your current financial situation and future plans.