Ins and Outs of a Bad Credit Mortgage | Part Four: Types of Mortgages for People with Bad Credit

Kate — Fri, 04 Sep 2009 20:03:31 +0000

There is a large variety of mortgages for people with bad credit history. The more you know about your options, the better prepared you can be when you start actively shopping for a mortgage. Remember that bad credit mortgages have some drawbacks – but generally, being able to purchase a home outweighs this.

2/28 Loan and Variations

The 2/28 loan is a loan that has a lower rate for the first two years and then increases at the beginning of the 3^rd year. There is also a 3/27 and 5/25 loan which function in a similar way – with a 3 year low rate then adjusting over the next 27 years, or a 5 year low rate adjusting over the next 25 years.

With these 2/28 type loans, the rate can increase as much as 6 percent. The idea behind this loan is to have borrowers improve their credit during the first two years and then refinance before the rate adjustment. With this type of loan, be careful to read the fine print. Often there are hefty pre-payment penalties for refinancing too soon. Also, carefully consider whether or not you will be able to repair your credit within 2 years. There are also additional costs in refinancing – make sure you are prepared for those if you choose a 2/28 loan.

Interest Only Loans

The idea behind an interest only home mortgage for people with bad credit, is that your payment amount covers only the amount of interest due each month, postponing principle payments. This kind of loan will keep your monthly mortgage payments smaller, allow you to qualify for a more expensive house and lets you repay your principle based on your own schedule.

However, there are big drawbacks to this type of loan. Because you are not paying down the principle, you are not building any equity. If the real estate market takes a downturn, which it has in many places, and your house loses value, you may have to pay to sell your home. The biggest drawback is that you do have to pay the principle eventually – and many people have a difficult time making payments over and above the required interest-only payments. Only consider this kind of loan if you can set up a regular principle payment (automated payments work well for this) or if you are expecting a large windfall – inheritance, regular bonuses at work, etc. with which you can make the principle payments.

Longer-term Fixed Rate Loans

Traditional fixed rate loans are over a period of 30 years. Newer loan programs offer a fixed rate mortgage for people with bad credit for a longer period of time, such as 40 or 50 years. The good thing about these loans is that the rate is fixed – there will be no surprises about your payment. The drawback is that by amortizing your loan over such a long period of time, you will be paying a substantially larger amount of interest. As a comparison, a 250k loan at 7 percent will cost you $146,399 more over the course of the loan at 40 years instead of 30 but would cost you about $100 less per month. This kind of loan can be a good option if you expect to be able to pay more toward the principle on a regular basis thereby cutting down the loan term.

80/20 Mortgage Loans

If you don’t have much, or any down payment, you may be able to qualify for a first and second mortgage combination. The first mortgage is 80 percent of the home’s value and the 2^nd mortgage is 20 percent. This type of loan generally helps you avoid mortgage insurance since the first mortgage is 80 percent or less. Rates on these types of loans are generally higher because there is zero down payment. This kind of loan can be a good option if you don’t have the money for a down payment but you can afford a higher monthly payment.

No Documentation or Stated Income Loans

These kinds of loans require far less documentation and are easier for people who do not have the traditional documentation required for loan applications. These kinds of loans have some of the highest interest rates, sometimes several percentage points above traditional mortgages.

Summary

Each of these loan types have their purpose. Consider your particular situation and know which of the above subprime / bad credit mortgages would work best for you and let your mortgage broker know. Be careful not to get talked into a program that won’t fit your needs or that will make your finances difficult to manage. The best way to go about a bad credit mortgage is to work to improve your credit as you build equity in your home, so that ultimately you have some equity in the bank and an improved credit score. That won’t happen if you take on a loan that is a bad fit for your situation.

In the next article, we will discuss finding mortgage lenders for people with bad credit.

Ins and Outs of a Bad Credit Mortgage | Part Five: Finding the Best Bad Credit Mortgage Lenders

Here is a list of all the articles in this series:

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Ins and Outs of a Bad Credit Mortgage | Part Four: Types of Mortgages for People with Bad Credit