You don't hear much about toxic mortgages these days, as lenders have learned all too well the hazards of steering borrowers into home loans they can't handle. But there are still some mortgages out there that, while they may not be foreclosure death-traps, can still be financial hazards for the unwary.
Most mortgages that are available today are pretty good choices - if you're the right type of borrower. If you're not, you'll do well to steer away from certain home loan types including some that are quite popular.
Here are four such mortgages most borrowers should avoid, unless they fit the described exceptions.
Adjustable rate mortgages (ARMs)
These aren't necessarily a bad type of loan, they just aren't a really good idea at a time when mortgage rates remain at historic lows. Sure, you can reduce your mortgage rate by a full percent or more off what you'd pay for a 30-year fixed-rate loan, but remember, that's only a temporary deal.
Based on historic trends, mortgage rates will likely be much higher when your rate resets in five to 10 years, so it's just not worth the risk of paying a lot more down the road in order to save a little right now.
This type of loan might work for you if: You're certain you won't stay in the home for more than a few years. ARMs can be a good deal for homeowners who expect to upgrade within the next seven years or who are in businesses where they have to relocate from time to time. But in a low-rate environment like we have now, they're not a good choice for those who are looking at long-term ownership.
This may come as a surprise, as FHA mortgages are one of the most popular types of home loans out there. But unless you're cash-strapped for a down payment or have damaged credit, you're probably better off going with a conventional mortgage.
FHA loans are relatively easy to obtain but they're expensive relative to conforming loans backed by Fannie Mae or Freddie Mac. This wasn't always the case, but fees on FHA loans have increased dramatically the past couple of years, making them much less attractive than they used to be.
First off, FHA loans require an upfront funding fee of 1.75 percent of the loan amount, in addition to other closing costs. You can roll that into the loan amount if you wish, so you don't have to come up with the money at closing, but it's still an additional $3,500 on a $200,000 mortgage.
In addition, you pay an annual insurance premium of 1.30-1.35 percent on a standard 30-year FHA mortgage, which is significantly higher than what you'd pay for private mortgage insurance (PMI) on a conforming loan with a down payment of less than 20 percent. PMI typically runs about 0.5 to 0.9 percent on a 30-year loan, depending on the size of your down payment.
In addition, with an FHA loan you're stuck paying the annual insurance premium for the life of the loan if you made a down payment of less than 10 percent. PMI can eventually be canceled when your loan balance falls below 80 percent of the home's current value or 78 percent of the original value.
This type of loan might work for you if: You have poor, but not terrible, credit that prevents you from qualifying for a standard loan, or if you have trouble coming up with a down payment. FHA loan requirements are less strict than those of conforming loans, so you may be able to qualify for one if your credit score kept you from qualifying elsewhere.
An FHA loan may also make sense if you don't have much money available for a down payment; FHA mortgages allow as little as 3.5 percent down. Be aware, however, that borrowers with good credit may be able to get a conforming mortgage for as little as 3-5 percent down, so be sure to check out that option first.
If you're had your mortgage for a few years, you've probably received a good number of offers from lenders inviting you slash your monthly payments by refinancing, potentially saving hundreds of dollars a month.
The problem with these offers is that the new monthly payment they're promoting is usually based on refinancing into a new 30-year mortgage. So if you originally bought your home with a 30-year mortgage 5-10 years ago or even more, that means going back to square one all over again. You may be able to get a lower rate than you're paying now, but much or all of those savings may be lost by stretching your payments out over a longer period of time.
A better option is to look to refinance into a 15- or 20-year fixed-rate mortgage, depending on how many years you have left on your current loan. You can still get a better rate than you're paying on your current 30-year mortgage - probably much, much better, in the case of a 15-year loan - while paying off your mortgage even faster than you are now.
You may even be able to get the lender to set the term for the new loan that matches the time you have remaining on the old one, so you stay right on schedule.
This type of loan might work for you if: You're tight for cash and need to reduce your monthly expenses. Many homeowners saw their incomes fall during the Great Recession, so what used to be an affordable mortgage payment is now a burden. So stretching out your loan term by refinancing to a new 30-year loan might not be a bad financial strategy in that case. You'll pay more in interest than you would with a shorter loan term, though tax deductions may help lessen the bite.
A mortgage from your regular bank
One of the biggest mistakes borrowers can make is to go directly to the bank or credit union where they currently have their accounts and simply apply there. While such institutions may offer special deals for their regular customers on many of the services they offer, mortgages typically aren't one of them.
That's not to say you can't get a great deal on a mortgage from your regular bank or credit union, but you don't want to assume that without shopping around. Rates and fees differ greatly from lender to lender, and you don't know what kind of deal you can get without shopping around to at least 3-5 of them.
This kind of loan might work for you if: Your regular financial institution offers you a mortgage with the best combination of rate and fees compared to everyone else. Otherwise, you're better off going elsewhere.