"Creative" Mortgages

Rapidly appreciating home prices have pushed mortgage payments out of reach for many buyers. So lenders offer a long menu of variable-rate mortgages and loan features that help buyers slash their up-front cash and initial monthly payments.

"Creative" mortgages can be a good thing for borrowers who understand the risks and have accounted for the worst-case scenario. For example, some of the newer mortgages keep monthly payments low by deferring repayment of all the principal.

If rates rise (and usually even if they don't), payments eventually go up, often dramatically. And if houses don't keep appreciating handsomely, you could find yourself "upside down" on a loan -- owing more than the house is worth when it's time to sell.

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Here's a rundown of the most common nontraditional mortgage loans you're likely to encounter, along with a look at the buyers they best suit and the risks they carry. Some are fixed-rate loans with features that make payments more affordable. Some are adjustable-rate mortgages with new twists (see "All About ARMs"to get up to speed on features shared by all ARMs ).

Use Kiplinger's calculators and those at www.mtgprofessor.com to see how the loan payments compare and to plan ahead to see if you could handle payments several years down the road.

What's What

Interest-only. This increasingly popular option can be a boon for borrowers whose income or expenses ebb and flow -- or for those who want to use their money to pay college bills or beef up retirement savings.

For the first five, seven or ten years, you can choose to pay interest only. But after that, the lender reamortizes the balance of your loan and you face larger, catch-up payments that include principal and interest every month. If you have an adjustable-rate mortgage, the interest rate could push those payments even higher.

Nothing down. If your income and credit are good but you can't come up with the traditional 20% down payment -- say, $75,000 on a $375,000 property -- or if your assets are tied up in other investments, you're a candidate for a no-down-payment mortgage. You may even be able to borrow up to 107% of the purchase price to cover closing costs. But you'll pay a higher interest rate and also have to buy mortgage insurance, which costs about 0.5% to 0.7% of the loan value and is added to your payment.

You can usually drop the insurance when equity rises to 20%. To avoid insurance, you could take out a first mortgage for 80% of the home's value, then finance the balance with a home-equity loan or line of credit tied to the prime rate.

Hybrid ARMs. If you expect to be in a house for a limited time, a hybrid ARM is a good choice. It has an initial fixed-rate period (three, five, seven or ten years), after which it converts to a one-year ARM. The longer the fixed-rate period, the lower the discount on the interest rate.

Option ARMS. These are the financing vehicles of choice for investors who want to pay the absolute minimum before reselling a property, and for first-time buyers who are stretching to purchase in a hot market and who expect their income to rise.

Over an introductory period of one to five years, you typically make either interest-only payments or even smaller payments based on a minimal initial interest rate -- as low as 1%. That low, low rate may wow you, but beware: It usually lasts only one month. After that, the rate adjusts every month with its index. Your monthly payment, however, adjusts annually, typically by no more than 7.5%.

The downside? The interest rate could rise as much as ten or 12 points over the life of the loan, and you could wind up owing more than when you took out the loan -- so-called negative amortization. If you make only the bare-minimum payment each month, the unpaid interest is added to the balance of your loan. Even if you make the full payment (which includes principal), if interest rates are rising rapidly, the loan balance will grow because of the cap on annual payment increases.

Meanwhile, every five or ten years, the lender will recalculate the payment to become fully amortizing, meaning that it will pay off the loan within the remaining term. And to protect itself -- not you -- the lender can impose a negative amortization maximum, say 110% to 125% of the loan balance. If your balance hits the maximum, then the payment jumps straight to the fully amortizing level.

Next: The Application Process