Based on a lot of people’s misconception, Interest only loans are not that bad.  Though,   they have had a hand in creating the mess we are in with the subprime market.  At that time, for some people to get in a home, interest only was their only option.  The loan started with a teaser rate then shot up.  When a person gets an interest only they need to ask themselves, why do you want interest only?  Do you plan on getting out before the 3, 5, 7 or 10 year teaser rate expires. 

This loan is perfect for someone that wants to live in the house for five or less years.  In the first 10 years of any loan the majority of the monthly payment goes towards interest.  If you are going to live in the house long term this wouldn’t be a good fit.  If you sell the house before the teaser rate expires, you will come out ahead before your monthly payment skyrockets.

ARM's vs. Fixed Loans

The adjustable rate mortgage (ARM) loan was a big cause for the melt down of subprime loans.  When people got their loan they didn’t understand that it was an ARM.  With an ARM loan the mortgage would adjust periodically based on the terms of the loan.  For example, say your 6.5% teaser rate jumps up to 8.5% and had the potential to climb higher three to six months later, would you be able to make your payment?  Having a 1500 dollar mortgage payment could jump up to a 2100 dollar payment and then later on it could possible increase more.  Getting a fixed rate mortgage when you know you will be living in the house long term is a good idea.  With the fixed rate, your interest rate stays the same.  Most of the people that are going into foreclosure now had the 2-3 year ARM’s with a prepayment penalty.

I personally like ARM’s, especially in times of low interest rates and you know you aren’t going to pay off the house or be in it for 30 years.  Even getting an interest only 7 year ARM makes sense to me if you are only going to live in the house 5 years.  But the key is to look at where you think you will be in 5 years and plan to make a move in 5 years.  The average first time home buyer lives in his house 5 years then trades up for a bigger house.

In laymen’s terms, an ARM can be a bit of a gamble and is not for everyone.  Fixed rate mortgages are great if you plan to live in your home long term or if you like to play it safe.

Option ARM's

It’s an adjustable rate mortgage with flexible payment options.  You are able to pick your monthly payment, monthly interest rate adjustments happen about every three to six months depending on the terms, and it has a low minimum payment in the early years.  This loan can carry a high risk of very large payments or owing more than you originally got the loan amount for later on.  With this type of loan you will see a low 1% or 2.5% interest rate, often called a teaser rate.  Then depending on the terms it bumps up and adjusts.  Usually this happens before six months.  This loan can be really bad if the person doesn’t know the draw backs.  In 5 years the borrower will have to automatically refinance.

PrePayment Penalty

A prepayment penalty can be really bad.  It’s a term within the contract that states if you pay off all or most of your loan, you will pay a penalty.  Penalties charges vary, but typically it is a percentage of the outstanding loan balance at the time of the prepayment.

This penalty has caused nightmares for many people.  A typically loan that has a prepayment penalty in it, is a 3 year prepay on a 2 year fixed ARM. That means a borrower is locked into the ARM part of his loan for one year and can’t repay, sell, or refinance the loan without paying the costly prepayment penalty.  This traps the borrower into paying for one year of higher monthly payments.

Banks categorizes prepayment penalties into two categories, soft and hard.  A soft prepayment penalty is if you sell your house you don’t have to pay your prepayment penalty.  On a hard prepayment penalty regardless if you refinance or sell the property a prepayment penalty will be charged.

I don’t recommend getting a loan with a prepayment penalty, but if you know you are financially able and can get a lower interest rate for it, you might want to consider it.

Stated Income and/or Assets vs W2 (Non Stated)