In part one of this series we discussed Adjustable Rate Mortgages (ARM’s) and pointed out why they are not the most viable option for the average homeowner. Today we’ll discuss Interest Only Mortgages (also known as Balloon Mortgages) and their applicable uses but we will also look at the darker side and explain why they can be a trap for homeowners and why they should be generally avoided.

What is an Interest Only Mortgage?
An Interest Only Mortgage is a loan in which for a set term the borrower pays only the interest on the principal balance, with the principal balance unchanged. At the end of the term the borrower may enter into another Interest Only Mortgage, pay off the principal in full, or convert the loan to a principal and interest payment (amortized) loan at the borrowers option.

Who should consider an Interest Only Mortgage?
An interest-only mortgage might be a good fit for someone with an income that is primarily in the form of infrequent commissions or bonuses. Another case is someone who expects to earn a lot more in a few years and believes they will be able to pay the principle in full at the end of the term. Additionally, someone who truly will invest the savings on the difference between an Interest Only Mortgage and an amortizing mortgage, and who is confident that the investments will make money is another prime candidate for such a loan.

Who should avoid an Interest Only Mortgage?
Financial advisors don’t recommend Interest Only Mortgages to traditional wage earners who take out moderate size home loans and don’t have a strategy for investing the savings. Additionally, the cost of the interest in such a loan can be significantly higher than as with a traditional amortized mortgage.

The Federal Reserve Board has more information on Interest Only Mortgage here:
http://www.federalreserve.gov/pubs/mortgage_interestonly/

This article is the beginning of a five part series devoted to the topic of refinancing a mortgage which will touch on numerous aspects, including the pros and cons of refinancing a mortgage. With the current crunch on the economy in the US, many homeowners are finding themselves in dire straits and are looking at refinancing their homes to help with their financial problems. Typically, when a homeowner is seeking to refinance their home, it is for one of two reasons: either to get a lower interest rate on their current loan to save money in interest payments over the life of the loan, they are interested in refinancing to cash out any equity they may have in their home for whatever reason.

Refinancing your mortgage can be done in a number of ways but recently, the two most common methods are applying for a refinance through a bank or by using the internet to seek a qualified lender. While there are many options available to homeowners, the most undesirable types of mortgage loans are adjustable rate (also known as flexible) and interest only (also known as balloon) mortgages. Both of the afformentioned types of mortgage loans are usually targeted at homeowners with little or poor credit or homeowners in a hurry to get the paperwork completed and to get themoney in their hands. Both should be avoided in almost all circumstances because they can be detrimental to a homeowner in the long run. Below is an explaination of adjustable rate mortages and the reasons why they are undesirable.

Adjustable Rate Mortgages
An adjustable rate mortgage (also known as an “ARM”) is a type of mortgage loan where the interest rate on the loan is periodically adjusted based on a variety of indexes and circumstances. The most common being the 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). Additionally, certain lenders have been known to use their own cost of funds as an index, rather than using other traditional indexes.

This is done to ensure a steady margin for the lender, whose own cost of funding will usually be related to the index. Consequently, the dollar value payments made by the borrower may change (increase or decrease) over time with the changing interest rate. In these types of mortgage loans the terms of the loan may also change depending on the initial note signed by the borrower. While these type of loans may seem beneficial when the economy is in good shape, they can be disastrous when the economy turns bad and the cost of funding for lenders increases thereby increasing the interest rates paid by the borrower.

The current mortgage crisis being experienced in the US is in part due to an overwhelming number of homeowners refinancing a few years back to ARM type mortgages when the real estate market was hot and lenders were eager to pass loans to anybody who could qualify. Many homeowners have recently found themselves held hostage by rising interest rates and are finding themselves forced into foreclosure due in part to rising interest rates.

The Federal Reserve Board has an informative Consumer Handbook on Adjustable-Rate Mortgages

This concludes part one of this series related to adjustable rate mortgages. Our next article in this five part series will be concentrated on interest only mortgage loans.