In traditional mortgages, homeowners pay down both the principal and interest on their mortgage loans at a fixed rate over a number of years. An alternative mortgage offers a homeowner a number of ways to pay back a mortgage loan through lower mortgage payments.
Payment Options for Alternative Mortgage Loans
An interest-only (I-O) mortgage requires just enough money each month to cover the interest on the mortgage loan. A homeowner can only take advantage of this for a set amount of time, however, before the mortgage lender will require larger payments for both interest and principal.
In a payment-option adjustable rate mortgage (ARM), the mortgage lender allows a homeowner to decide whether he or she wants to:
- make payments on both the principal and interest;
- make payments only on interest for a set amount of time;
- make a monthly minimum payment, which may be less than the interest, for a set amount of time.
Important Alternative Mortgage Information for Homeowners
Homeowners must remember that low or interest-only payments are only temporary. Mortgage lenders expect the entire amount of the mortgage loan, plus any built-up interest, to be paid eventually. Andrew Olszowy of the Federal Reserve Bank of Boston advises that many homeowners who forget this are hit with “payment shock” once their mortgage loans are recast and payments begin on both principal and interest. “The fully indexed, fully amortizing payment might be 50 percent more or even double the original payment,” he writes in his report "Alternative Mortgages: Managed Risk or Gamble", available on the bank's website. “If the borrower could only afford the minimum payment, the financial hit could be disastrous.”
A homeowner may also experience negative amortization if he or she is only making minimum monthly payments. Because the payment is so low, it is not paying down the principal or even the monthly interest. The result? The interest not paid down keeps adding on to the loan, and homeowners may end up owing more than they originally borrowed.
When An Alternative Mortgage Helps Homeowners
According to the Federal Reserve Board's 2007 report "Are They for You? Interest-Only Mortgage Payments and Payment-Option ARMs", there are still advantages in alternative mortgages for certain homeowners. A homeowner in any of the following financial situations may find the low, flexible payments of an interest-only mortgage or payment-option ARM beneficial:
- Homeowner has modest income currently, but expects income to jump in future. (Possibilities include finishing training or degree with prospects of a higher-paying job)
- Homeowner has irregular or seasonal income, and will make low monthly payments during lean months but make larger payments during higher-income months
- Homeowner has sizable home equity and will use money saved on mortgage payments to make wise, higher-paying investments elsewhere
Homeowners must be very confident in what the future holds for themselves, the economy and the housing market to decide whether the risk of an alternative mortgage is manageable. Other ways to find and choose an affordable mortgage loan can be found in this article.
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