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If you can’t qualify for a conventional loan or just aren’t interested in one, you may be wondering what other home loans are out there. Well, there are lots of options to choose from. And many of those options fit under the umbrella of “nontraditional” mortgages.
So what is a nontraditional mortgage, and is it the right choice for you? Our guide will explore the different types of nontraditional loans – and some of their benefits and drawbacks.
What Is a Nontraditional Mortgage Loan?
A nontraditional mortgage is a unique loan that doesn’t fit the requirements of a conventional loan or an unconventional loan. Nontraditional mortgages often have lower credit score and debt-to-income (DTI) ratio requirements.
These mortgages tend to have unusual repayment terms and may allow borrowers to defer their payments or only pay interest until the end of the loan.
Characteristics of a nontraditional mortgage
Nontraditional mortgage loans usually have these traits:
- Typically, they have a nonstandard amortization schedule.
- They have flexible repayment terms.
- They present a higher risk for the borrower and lender due to their irregular payment terms and lower credit score requirements.
- They are easier to qualify for than conventional loans.
- Some borrowers pay higher interest rates.
- They may offer principal or interest deferral.
- They are issued by private, nontraditional mortgage lenders, like businesses or home sellers, rather than banks, credit unions or online lenders.
Nontraditional Mortgages vs. Other Types of Loans
With a “traditional” mortgage, also known as a conventional mortgage, the repayment terms are fairly straightforward. You borrow money from a lender at a fixed or variable interest rate. Then you make monthly payments toward the loan’s interest and principal until it’s paid off. After that, you own the property outright.
With a nontraditional mortgage, the repayment terms are a little different to give other options to home buyers who may not qualify for a conventional mortgage. Nontraditional mortgages allow borrowers to throw out the regular payment model in favor of a more flexible repayment schedule.
The alternative repayment schedule can look like only paying interest on the loan, and at the end of the loan’s term, making one large payment on the outstanding loan balance. Or it can look like deferring your payments until the end of the loan when you pay the entire loan balance and its accrued interest.
Nontraditional or nonconforming?
Nontraditional loans are often confused with nonconventional or nonconforming loans. Nontraditional loans are different from nonconforming loans – but most nontraditional loans are nonconforming. So, what’s the difference? And how can one loan be both?
Nonconforming loans are loans that don’t meet Fannie Mae and Freddie Mac’s standards for purchase, meaning they aren’t conventional.
However, many nonconforming loans, like Federal Housing Administration (FHA) loans, Department of Veterans Affairs (VA) loans and U.S. Department of Agriculture (USDA) loans, operate like conventional mortgages because of their repayment models and schedules.
Even though you pay these loans back the same way you would pay back a conventional loan, they’re considered nonconforming because the loans are government-backed and often have lower credit score and DTI requirements.
Nontraditional loans don’t conform to Fannie Mae and Freddie Mac’s standards and don’t have typical repayment schedules. With a nontraditional loan, you may not have to make payments every month. You may only pay interest for a few years – or the entire life of the loan.
Types of Nontraditional Mortgages
There are three main types of nontraditional mortgage loans: balloon loans, interest-only mortgages and payment-option adjustable-rate mortgages (ARMs).
A balloon loan is a mortgage that operates on a lump-sum payment schedule. That means that at some point in the life of your loan (usually at the end), you’ll have to pay the outstanding loan balance with one larger-than-average payment.
Depending on your lender, you may make monthly interest-only payments and one big principal payment at the end of the loan, or you may make payments that are a combination of interest and principal, paying off a somewhat smaller lump-sum balance at the end.
With a balloon loan, you’ll have low monthly payments, which can free up money for other goals, like saving or paying off other debts, before you make your lump-sum payment on the loan. Balloon loans can be a good idea for homeowners who know they won’t be in a house for very long or for homeowners who can pay the lump-sum amount quickly and avoid making monthly mortgage payments for years.
An interest-only mortgage is similar to some balloon loans. A borrower may be allowed to only pay interest on the loan every month rather than pay interest and principal. Unlike a balloon loan, you generally only pay interest for a set number of years with an interest-only mortgage. After that, your balance starts amortizing, which can dramatically increase your monthly payment.
Most interest-only loans are ARMs. With an ARM, the interest rate on the loan is periodically adjusted each year based on current market rates, causing your monthly payments to either increase or decrease. A common interest-only mortgage option is the 5/6 mortgage. The 5 represents the number of years you’d only pay interest, and the 6 indicates that your rate will be adjusted every 6 months.
Interest-only fixed-rate mortgages exist, but they are rare. ARMs can be more expensive long term, so if a rate that is guaranteed not to increase sounds better to you, consider refinancing to a conventional fixed-rate loan.
A payment-option ARM adjusts every month and allows borrowers to decide how they want to pay down the loan. Borrowers are given several payment options to choose from, including 15-, 30- or 4-year fully amortizing payments, minimum-and-over based payments, and even interest-only payments (which are similar to balloon loans).
Payment-option ARMs can be very high risk to borrowers since there’s a good possibility that your monthly payments will increase and the amount of debt you owe may also increase while you’re attempting to pay down the loan, depending on your rate and how much over the minimum you’re paying each month on the mortgage.
These loans can be beneficial to buyers working with shorter-term investments but may prove too risky for homeowners in search of a good long-term loan.
The Pros and Cons of Nontraditional Mortgages
Nontraditional mortgages have a reputation for being riskier loans for borrowers, but depending on the situation, they can also be very useful. To see if a nontraditional loan might work for you, let’s review some of the pros and cons.
Most nontraditional mortgages allow you to make lower monthly payments – or even pay off your entire principal balance in one lump sum.
One perk of paying your entire balance off at a later date is that it gives you a chance to save money because you’re not making large monthly mortgage payments.
With loans like an interest-only mortgage, your mortgage payments are more affordable during the interest-only period at the start of the mortgage than they would be at the start of a conventional mortgage where your payments include principal and interest.
Nontraditional loans are often short term. With an interest-only loan, if you make payments toward your principal on top of your monthly interest payments, you’ll lower the amount you’ll have to pay at the end of the loan.
Not all nontraditional loans have high interest rates. But many of them are ARMs, and with an ARM, your loan’s interest rate could increase at any time. And because many nontraditional mortgages have less strict credit and DTI requirements, the rate may be higher to account for the risk of defaulting on the loan.
While flexible payment options can be very useful, they can also present a danger for borrowers. With some nontraditional loans, if you only make minimum payments or defer your payments, the interest can build up fast, which will increase the total amount you owe. The more you owe, the harder it may be for you to make your payments when the loan comes due. When that happens, you may be at greater risk of default than you might be with a conventional loan.
If you have an interest-only loan and plan to sell your home before the interest-only period ends but the value of your home drops, you may not be able to sell your house, or you may have to sell the home for less than you owe on the mortgage.
With many nontraditional loans, the option to only pay interest is great because it allows you to make lower payments – but you aren’t building equity in the home. If you sell your home with little to no equity, you may end up making nothing or even paying to sell.
Are Nontraditional Mortgages a Good Idea?
Nontraditional mortgages offer lower monthly payments, flexible payment options and typically have less strict requirements to qualify than conventional loans, which makes them very attractive.
These loans can be useful if you need to finance a short-term investment or are in another situation that calls for an (initially) low-cost nonconventional loan. However, these flexible options can pose a risk to borrowers, especially when paired with higher rates.
Before deciding to get a nontraditional mortgage, be sure to do your research and determine whether the loan would be a good option for you even in a worst-case scenario where your monthly payment increases by a lot.
The Bottom Line: Be Careful When Considering Nontraditional Loans
Nontraditional loans are an option for borrowers in need of unique financing to suit their needs, but these loans come with risks you should seriously consider before applying.
For many borrowers, a traditional or conventional loan may be a better, more affordable option.