Mortgage Mistakes to Avoid

1.  Getting a loan with a prepayment penalty

Some loans have prepayment penalties, meaning that if you pay the loan off before a predetermined date you are charged a fee.

Prepayment penalty periods vary but are often two to three years. The penalty amounts are typically 1 to 3 percent of the loan amount, or the equivalent of 6 to 8 months of interest.

For example:  If you had a $200,000 loan with a 2% prepayment penalty and you paid off the loan by selling your home before the prepayment penalty period ended, you would have to pay an additional $4,000 in addition to the principal.

The same situation can occur if you refinance during the penalty period, since technically you pay off the first loan when you refinance with a new loan.

Prepayment penalties are supposed to be disclosed in the loan paperwork, but borrowers still often end up with them unknowingly, so ask your loan officer about it directly just to make sure.  The worst time to find out about it is when you’re signing the paperwork on the sale of your own home!

Possible Exception:

When might it be reasonable to take a loan with a prepayment penalty?  I’m sure opinions vary, and I am not a financial expert or advisor, so ultimately you have to use your best judgment.  (Yes, it’s the usual legal waffling verbage. )

However, based on what I’ve heard from lenders that I trust, a possible scenario would be if:

a) buyers were certain they would be in both the home and the loan for well past the penalty period,

b) taking a loan with a prepayment penalty allowed them to get a significantly better rate or overall deal on the loan, and

c) they entered into the situation KNOWINGLY – understanding that nothing is 100% sure, and that if unforeseen circumstances forced them to move or refinance sooner they would be charged the prepayment penalty.

The bottom line is, always BE INFORMED and make sure you know exactly what you’re signing on to.

 

 2.  Getting a negative amortization loan

Just to be clear, a typical loan payment is PITI – Principal, Interest, Taxes and Insurance.  Let’s disregard the Taxes and Insurance for now, to make this point:

When you pay Principal and Interest, the Interest portion pays down what accrued (basically, keeps you at par), and the Principal portion pays down your loan amount.  Your total loan balance goes down with each successive payment because you’re paying off Principal.

When you pay on an Interest Only loan, you don’t reduce the loan amount but you don’t increase it either – you’re just paying interest as it accrues and keeping the Principal portion of the loan balance the same.

When you pay on a negative amortization loan, you get a third option that allows you to pay no Principal and less than Interest Only.  The unpaid portion of the interest gets tacked onto your total loan amount, interest begins to accrue on that as well, and with each successive payment you owe more on your mortgage than you did before.

Needless to say, this is a terrible situation to get into unknowingly.

Just as with a prepayment penalty, negative amortization is supposed to be disclosed in the loan paperwork.  Howver, I’ve seen an intelligent, educated borrower end up with a negative amortization loan, making minimum payments without realizing what was going on, so just be aware that it’s something to check with your lender about.

(Just so you know, your lender will probably react in horror – most would never dream of putting a borrower unknowingly into a “negative am” loan.)

Possible Exception:

Not for the faint of heart.  A possible exception might be:

An investor who plans to throw a lot of money into something like converting an apartment building into condominiums, and has great expectations for incoming cash from the condo sales in a relatively short period of time.  It may be worth it to that person to make lower payments and increase their loan balance in the short term if it helps them get the loan and have more cash on hand to complete a highly profitable project.

Unlike the prepayment penalty, which has set limits and goes away if you can just hang onto your mortgage for a while, negative amortization is an escalating process that gets worse as time goes by.

Think of it as the financial equivalent of big wave surfing.  There are very few people who are really prepared to get towed a mile offshore to surf a monster wave without meeting a mishap, and the same goes for most borrowers when it comes to negative amortization loans.

Please note that I am not a financial expert or advisor, and the information above constitutes my opinion, not professional or legal advice. Please consult a qualified financial expert regarding your financial decisions.