As I’ve said before, there are really not any bad loans. If there were, people just wouldn’t take them. There are, of course, lots of bad loan situations. Loan products, like borrowers, are complicated and have different advantages and disadvantages depending on circumstances. What follows is a vary small sampling of loan programs along with my explanation of how they work, who they benefit, and who should probably do something else – or maybe nothing at all.
Fixed-Rate Loans: Yawn… pretty boring loan. Borrower makes the same payment for the term of the loan, and the loan is paid off. The loan balance always goes down; the payment doesn’t change.
Who should get it: Most people. It’s predictable and safe; far-and-away the most popular loan type.
Who should consider something else? There two groups that may want to consider another option: First: People whose income is highly irregular. The problem with this loan is if you can’t make the regular monthly payment, you are in default – even if you can pay it current down the line. People with highly seasonal income, etc. might want to consider a loan that allows a lower payment for periods of time. Second: People who will be making a substantial principle payment. If you borrow $300,000, and six months after you take out the loan you make a $150,000 principle payment, your payment does not go down. Sure you will pay off the loan way before the 30-years is up, but you will be required to make the same payment you originally agreed to regardless of how much you owe.
Adjustable Rate Mortgage: There are lots of types of ARM loans, but the basic principle is the same. The interest rate adjusts at pre-determined times based on the movement of some index. The interesting thing is that historically people that took adjustable rate loans pay less in interest than the people that took the fixed-rate option.
Who should get it: Obviously people that are a bit more risk-tolerant are better suited to adjustable loan products. But also people that expect to make principle payments can benefit from the fact that most adjustable loan programs will adjust the payment based on the combination of rate, remaining term and loan balance. This allows people who make big principle payments to enjoy a lower payment without having to refinance.
Who should consider something else? Anyone who will be adversely affected by having their rate go up should probably avoid loans where this is possible. (Duh.)
Option ARMs: This loan program has been around for a long time, but the 1% teaser is a relatively new twist. This is an adjustable rate loan, usually based on an index that moves slowly. The payments are set on one schedule, while the interest rate changes more frequently – usually every month. The borrower is given the “option” of paying the minimum payment (which is usually based on an artificially low “teaser rate” and is less than the interest payment,) the interest payment (which at least allows the loan balance to stay the same,) or a fully amortized payment. At some point however, the loan payment must be adjusted to a level that pays off the loan within its term; this can result in a very large payment increase (actually a really-really big increase) – especially if the borrower has always taken the lowest payment option.
Who should get it: People that have irregular income most benefit from this type of loan. Self-employed borrowers, professionals who get bonuses annually for a substantial portion of their income, or anyone with a seasonal income flow may like to be able to pay a lower payment during the low cash-flow times and then catch it up when the cash comes in.
Who should consider something else? Anyone who does not understand the consequences of the negative amortization should not take this loan. This is not a loan for the unsophisticated or financially ignorant borrower, and selling it to these borrowers was a recipe for disaster. People who “really need that low payment” should buy less house – not take this loan.
The sub-prime 2/28 or 3/27: This is the loan that is commonly blamed for the whole housing mess. It was an adjustable rate loan that had the interest rate fixed for the first two or three years. After that period it became a basic 6-month adjustable rate loan. Once the fixed-rate period was over, the loan adjusted to a fairly high rate due to the high margin. Other typical features included a pre-payment penalty for the first two years and an interest-only option for the first two years. This loan was intended to be a somewhat unfavorable option for someone who could not get a better loan product. It typically required a 20% to 30% down payment, and allowed for stated income and lower credit scores.
While public opinion seems to be that this is a very bad loan, I believe it was actually too good a loan. The reason people liked the 2/28 or 3/27 loans, was that they had a much lower rate then the fixed rate option (that was almost always available) and had pretty good terms considering the borrower’s profile. The purpose of this loan was to get someone into a house with a loan that was not too bad initially, who could then refinance once their situation improved. What killed this loan – and by extension the housing industry – was when investors began allowing 2nds to replace the buyer’s cash investment. The combination of poor quality borrowers with no investment created disaster.
Who should get it: You probably think that nobody should have ever gotten this loan, and you would be close, but not right. For people who needed to buy, had the cash, and were getting their act together, this was not a bad deal. If they really did get their act together, then they refinanced and were good buyers. If they were still not qualified, then the loan adjusted to what they deserved – and high-rate loan with not-great terms. If they defaulted, they lost their investment and someone else bought the home.
Who should consider something else? My personal opinion was, and still is, that it’s best that people, who are not qualified for conventional or government financing, work on their situation to make themselves better qualified before trying to buy. This should be a last option, so in fact most people should probably not take this loan.
These are just a few examples of different loan programs and – most of which are not now avaible now. This is either because there are no investors willing to buy these loans as investments, or because the have been effectively or actually outlawed by the government. My hope is that as the markets improve that some of these and other programs will again become available. Of course I’m not advocating for the type of insanity that caused all of the problems. I am for informed choices for borrowers who can truly benefit from different programs and program features after consultation with responsible lenders. Time will tell…
