Most homeowners finance the purchase of their homes through “conventional” sources like banks and mortgage lenders. For example, a common configuration for a home loan these days is about 5% interest rate, fixed rate, 30-years, and one that will pay off in full in those 30 years. No balloon payments due and no negative amortization situation going on. (Negative amortization is when the amount you pay monthly is not enough to pay the accrued interest which means you can end up owing more on this type of loan in the future than what the starting principal amount was.)
These type mortgages are not that common at all for obvious reasons – some of the reasons are the risk is quite high relatively speaking and one must have quite a bit of liquid cash to lend to someone. Who else can bear that risk and have that cash in spades? Other than traditional banks?
But there are individuals out there who use their money to finance someone else’s purchase of a home and they are the mortgage lender for that individual except the fact that they are not a “business” that is in the usual business of giving mortgage loans.
Why is that significant? Because the terms are usually not as favorable as those of a big bank and a good proportion of my clients who have these type mortgages seem to be caught off guard by the terms after the fact. It’s a sort of what comes first, the chicken or the egg argument? Less credit worthy clients can’t qualify for conventional mortgages so they seek out these mortgages. Smaller, less “conventional” lenders can’t attract more credit-worthy clients so they must charge more interest (to reflect the inherent risk) to these unconventional borrowers.
So be careful when you enter into one of these arrangements. Understand what “market” rate is for conventional mortgages and determine if your terms with the unconventional lender is worthwhile for home ownership. When you notice the difference, ask yourself if the difference is palatable for you both financially and morally. If a conventional home mortgage’s interest rate is 5% and you are paying 10% with a private lender, is the total amount you pay on the loan worth the home you are buying? Should you wait a little longer, wait for your income to increase first, take steps to improve your credits score, before you enter into mortgage agreement with an “unconventional” lender?
A common pitfall is the “balloon” clause. A client may be enticed by a low monthly payment and believe that is very affordable. But they overlook or under-evaluate a 5-year maturity with a balloon clause. They underestimate that balloon amount and/or underestimate how quickly those 5 years can go by. I don’t believe these unconventional lenders do that to trip up the borrower. But those lenders have to minimize their risk and a 5 year loan limits their exposure to that borrower and is also practical – a person’s life-span (to collect on a loan) is much shorter than a bank or institution’s life-span.
So consider that carefully – will someone deem you to be credit worthy in 5 years to finance the payoff of the balloon amount? Are you willing to risk a foreclosure of your home if you are unable to find financing then? More of my clients who have unconventional mortgages tend to have buyer’s remorse after the fact than clients who have conventional mortgages. This is definitely not a plug for conventional mortgages especially since many mortgage companies have been sanctioned in recent years by state and federal agencies. Buyer beware for sure!
By W M Law Attorney, Karen Maxcy