What it means
A conventional mortgage is deliberately dull: a fixed or tracked rate, a set term, and a payment that clears both interest and principal by the end. Exotic mortgages break one of those elements, usually the requirement to repay principal, in order to make the monthly figure look smaller.
The common variants are interest-only loans, where nothing comes off the balance during a set period, and payment option adjustable rate mortgages, where the borrower picks from several payment levels each month. A third variant is the negative amortisation loan, where the minimum payment is less than the interest due and the shortfall is quietly added to the debt.
The danger is payment shock, the jump that arrives when the introductory phase ends and the loan converts to full repayment at a higher rate. A payment can rise by half or more overnight, and it does so on a schedule the borrower agreed to years earlier and rarely remembers.
These products are not automatically wrong. An interest-only loan can suit somebody with genuinely lumpy income, a bonus-heavy banker or a business owner, provided there is a credible plan for repaying the capital rather than a hope that prices keep rising.
Regulation after 2008 changed the landscape considerably. Lenders in most developed markets must now assess affordability at the reset rate rather than at the teaser rate, which has removed the worst products and pushed the remainder towards borrowers who can document how the capital will be repaid.
In practice
Real-world examples.
Example
A self-employed architect takes a five year interest-only mortgage on a $600,000 house, paying $2,000 a month at 4%, and commits to clearing $50,000 of capital each January out of her practice's profit share.
Example
A buyer in a hot market takes a payment option mortgage in order to afford a larger property and chooses the minimum payment every month. Two years later the balance has grown rather than shrunk, the loan recasts to full repayment, and the house has to be sold.
Example
A lender reviewing its book finds that a quarter of its interest-only loans mature within four years with no documented repayment plan. It writes to every one of those borrowers offering a switch to a repayment loan with no arrangement fee.
Formula
Calculation
Interest-only monthly payment = balance x annual rate / 12
Fully amortising payment = balance x r / (1 - (1 + r) to the power of -n), where r is the monthly rate and n the number of months
Take a $400,000 loan at 5%. The interest-only payment is $400,000 x 0.05 / 12 = $1,666.67 a month, against $2,147.29 on a fully amortising 30 year loan at the same rate, an apparent saving of $480.62 every month.
After five interest-only years the balance is still $400,000. If the loan then resets to 6.5% over the remaining 25 years, the payment becomes $2,700.83 a month, a rise of $2,700.83 - $1,666.67 = $1,034.16, or 62%, and the borrower has not repaid a single dollar of the original debt.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Two invented households, the Ashgroves and the Peniketts, each bought a house at $500,000 with $100,000 down and borrowed $400,000 in the same month.
The Ashgroves took a straightforward 30 year repayment loan at 5%, paying $2,147.29 a month. The Peniketts took a payment option mortgage whose interest accrued at 7% but whose minimum payment was calculated on a 2% teaser rate, just $1,478.48 a month, a difference of $668.81.
At 7%, interest on $400,000 runs at $2,333.33 a month, so the Peniketts fell short by roughly $855 every month and that shortfall was added to their debt. After twelve months their balance had grown to about $410,600 while the Ashgroves had begun repaying theirs, and in this fictional case a $669 monthly saving had cost them more than $10,600 of extra borrowing in a single year.
Watch out
Common mistakes.
- Judging a mortgage by the first monthly payment rather than by what that payment becomes once the introductory period ends.
- Believing that rising house prices will solve the repayment problem, which works right up until prices stop rising.
- Confusing an interest-only loan with a cheap loan, when the total interest paid over the life of the debt is usually higher because the balance never falls.
Questions
People also ask.
Are exotic mortgages still available?
Yes, but mainly to borrowers who can evidence high or irregular income and a clear plan for repaying capital, and affordability is now tested at the reset rate.
What is negative amortisation?
It is what happens when your payment is smaller than the interest accruing, so the unpaid interest is added to the loan and the balance grows rather than shrinks.
Is an offset or flexible mortgage exotic?
Not usually, because those still repay capital on a normal schedule and simply change how interest is calculated or when payments can be varied.
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