When Circumstances Dictate, Try Non-traditional Loans

When Circumstances Dictate, Try Non-traditional Loans

When considering non-traditional mortgages, the first thing to realize is that, with the possible exception of reverse mortgages, the entire spectrum involves financing in the red zone, which is to say that nontraditional financing generally involves higher costs than traditional mortgages.

This does not mean that pursuing a non-traditional mortgage always means the borrower is in trouble, but it does indicate a red flag. Just because the borrower may be seeking financing outside of the standard or traditional methods that does not mean there is trouble afoot. However, it should be said up front that if a borrower believes that a non-traditional mortgage is some way to beat the system, they are not only incorrect, they are dead wrong. Non-traditional mortgages are almost always more expensive than traditional loans and every borrower, at some point, has to pay the lender.

Non-traditional mortgages, to put it one way, are not get-out-of-jail-free financing options. Quite the opposite.

There are several types of non-traditional mortgages, but let’s see what a traditional mortgage is first. Also, to sort out confusion, let’s review reverse mortgages. Although they are not really mortgages at all, even if they share some similar aspects.

A traditional loan is simple. You borrow $100,000 to buy a house. First, you put 10 percent to 20 percent or even more down and you finance the rest for up to 30 years at a fixed rate (say 6.5 percent) or an adjustable rate, which varies according to some money market benchmark, like the London interbank offered rate (or Lipor), which is an average rate banks pay when borrowing from each other.

As it looks, a traditional loan depends on a fairly sound borrower with a good credit history and a solid down payment on the loan.

Now, let’s review a variety of payment option mortgages. These are the so-called non-traditional loans and they are all variations of each other.

First, while this is basic, it needs to be understood that lenders charge interest on a loan. This is their profit. Since they want to ensure the profit doesn’t slip away if a loan goes sour, the initial payments made are mostly made up of profit (the interest) and only slightly made up of principal (the amount borrowed). Over time, this ratio reverses so that more principal than interest is covered by each payment.

With this in mind, an interest-only mortgage is easy to understand. Payments are all interest with no principal paid, which means the amount of principal owed does not diminish. It also means monthly payments are smaller.

The advantage to this loan has nothing to do with no principal being paid. That is, frankly, the disadvantage of these deals.

The advantage is that payments are smaller and these loans are selected for that. Common reasons for doing so include borrowers with widely fluctuating income, so that they can only afford to pay principal when they are flush with funds. Also, buyers who want to flip a house quickly – fix it up and sell it within six months – may want an interest only loan, because by the time principal is owned, they have already sold the house.

As you might expect, interest-only loans are, by definition, balloon payment loans, which means that they are only temporary or short-term arrangements. As mentioned, everyone has to pay the principal eventually, so these loans only put off the inevitable.

Variations on the theme include payment arrangements that do not even cover the entire interest on a loan. Again, these loans simply catch up to the borrower, eventually. They are useful, however, if your circumstances apply.

The other non-traditional mortgage is the so-called a subprime mortgage, but these are simply variations of a traditional loan shaped to fit the bank’s risk assessment. They are loans given to borrowers with low credit scores or small down payments.

But instead of charging less for burdened borrowers, to see that a loan is successful, lenders go the other way. Higher risk loans mean higher charges, which the lender believes it is owed for taking on the increased risk. This makes subprime mortgages more expensive than traditional loans.

Finally, there are reverse mortgages, which are not, essentially, mortgages at all. Only incidentally are they connected, as the money from a reverse mortgage can certainly be used to buy a house. But the money can also be used for anything else from daily living expenses to healthcare to a vacation.

To understand the reverse mortgage, first note that the principal that is paid down on a loan counts on paper as equity. That is the value of what the borrower owns. If half of the principal of a $100,000 loan is paid off, the borrower has $50,000 in equity – or more if the value of the house has gone up.

Recognizing this, lenders can agree to a reverse mortgage arrangement in which the $50,000 or a portion of that is turned into a line of credit paid to the borrower in a lump sum or in monthly installments. It can also be paid on an as-needed basis, the same as any line of credit loan.

Reverse mortgages are only available to borrowers age 62 or older, which hints at their appeal and their use. Instead of selling the home they have lived in for decades, an older couple, for example, can have the equity in their home to spend while they stay where they are.

Again, this is no magic trick. If you borrow money through a reverse mortgage line of credit, eventually the lender needs to be paid. After years of lowering the principal owed on a home, a reverse mortgages adds back to the amount owed. If circumstances apply, these loans are very useful, but the debt is paid, eventually, sometimes by the heirs of the estate after the borrower has died.

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