5 Risky Mortgage Types To Avoid

If there's anything we've learned from the subprime meltdown of 2008 and crash of 1987, it's that we should all proceed with caution when borrowing money to purchase or refinance a home. The type of mortgage you choose can mean the difference between one day owning your home outright or finding yourself in the middle of a foreclosure or even a bankruptcy. In this article, we'll discuss the types of mortgages that people most commonly have trouble with and explain why they are a bad idea when matched with the wrong borrower.

What Makes a Mortgage Risky?
Because of the housing crisis, many of us have come to believe that certain types of mortgages are inherently risky. However, mortgage experts will tell you that a risky mortgage is really a loan product that is not matched with the repayment ability of the borrower.

Keith T. Gumbinger, Vice President of HSH Associates, agrees, saying, "believe it or not, the products available [around 2009] weren't especially risky, for the right audience." The problem was that certain mortgage types were being matched with the wrong borrowers, and lenders were telling borrowers, "you can always refinance." This may have seemed true when home prices had been rising for years, but isn't true when home values are declining.

Housing market statistics shortly after the 2008-2009 crisis support these assertions. According to the Mortgage Bankers Association's National Delinquency Survey, in the second quarter of 2010, the types of loans with the highest percentage of foreclosure starts were subprime adjustable rate mortgages (ARM), which had a foreclosure start rate of 3.39%. ARMs, with their changing interest rates, are a particularly risky mortgage product for borrowers with less-than-ideal financial situations.

By comparison, the survey reported that VA loans had a foreclosure start rate of 0.70%, prime fixed loans 0.71%, FHA loans 1.02%, prime ARMs 1.96% and subprime fixed loans 2.3%. This data indicates that any type of mortgage can be a bad idea for a subprime borrower, and that even prime borrowers can get into trouble if they don't understand ARMs.

In fact, even fixed-rate mortgages can be detrimental to borrowers. Let's look at our first risky mortgage type.

1. 40-Year Fixed Rate Mortgages
Borrowers with fixed-rate mortgages may have a low rate of foreclosure, but that doesn't mean that fixed-rate mortgages are always a good idea. The 40-year fixed-rate mortgage is one such product because the longer you borrow money for, the more interest you pay.

Let's say you want to buy a $200,000 home with a 10% down payment. The amount you'll need to borrow is $180,000 ($200,000 minus $20,000).

At an interest rate of 5%, here are the monthly payments and the total amount you'll pay for the home under various terms if you keep the loan for its life:

The chart above is a simplified comparison. In reality, the interest rate will be lowest for the 15-year loan and highest for the 40-year loan. Here's a more realistic comparison: