Investing Trends

Financial salespeople such as investment advisors and mortgage brokers are recommending 'new' types of mortgages for improving cash-flow, freeing up money to invest, and having money to take that dream vacation. Their sales pitches sound so enticing. But here's what they don't tell you.

In the past, the only decision to make when getting a mortgage was whether you wanted a fixed or adjustable rate. Now, seniors are being pitched interest-only mortgages, option-ARMs and reverse mortgages. It's easy to become confused and overwhelmed. The result is you can spend thousands of dollars in fees and end up with a mortgage that doesn't meet your needs.

In a traditional mortgage, part of each monthly payment covers interest while the rest goes to pay down the principle amount you borrowed. With each payment you are decreasing the amount you owe and increasing your equity.

Interest-only, option-ARMs and reverse mortgages function quite differently from the traditional mortgage. Instead of decreasing the amount you owe, you will most likely be maintaining the same level of debt. In some cases you will actually be increasing the amount you owe—you will be going further into debt with each payment you make!

With an interest-only mortgage, you pay the amount of interest due each month for the first 10 years. This is still a 30-year mortgage, but you don't begin paying down principle until year 11. Since there isn't any money going to principle, your monthly payments will be less than with a traditional mortgage only during those first 10 years.

This can make sense in certain situations—especially for cash-strapped seniors. Since the monthly payment is lower, it will reduce what you take out of your retirement account. That means you won't have to pay income tax on that retirement money. It can continue to grow tax-deferred.

I only recommend this strategy as long as there remains at least 25% home-equity. Also, it's not a good idea to tap into equity during the refinancing to buy a new car or take a fancy vacation. This isn't free money. Spending the equity in your home is no different than spending the money you've invested in a CD or mutual fund.

The option-ARM is being heavily promoted these days—but watch out! They're sold based on their low introductory interest rate (as low as 1%) and a special low payment. And they give you the 'option' of the kind of payment you make each month. You can make the special low payment, you can pay the interest-only, or you can pay principle and interest just like a traditional mortgage.

On the surface this sounds good, allowing seniors to increase cash flow or to free-up their home equity so they can invest it in other, 'better' investments such as equity-indexed annuities.

But don't do it. People buying this mortgage think they are getting a great deal because of the low interest rate and the low payment. What they don't realize (and what isn't properly explained to them) is that each time they make that special low payment they are going further into debt.

Think about it. Let's say you borrow $200,000 and the interest-only payment is $1000 per month. If you instead make a payment of $400 then the $600 in interest you didn't pay is added to what you owe. So next month the interest due is based on owing $200,600. Do this for a year and you have dramatically increased what you owe. Instead of saving money like you thought, you were actually spending the equity in your home on other things.

The low introductory rate only lasts a short time, often just a few months. After that, you can end up paying a higher interest rate than if you went with a traditional mortgage in the first place. The costs of getting an option-ARM are higher as well. These only make sense in a few isolated situations. Most people should stay away from them.

Next week I'll talk about the advantages and disadvantages of reverse mortgages. I will also share stories from my readers that illustrate the shady mortgage-related sales pitches that are now being used. Don't buy one of these mortgages until then.