What it means
A traditional mortgage has a fixed or simple variable rate and level monthly payments that gradually pay off both the interest and the original loan (the principal). By the end of the term, the balance is zero.
Non-traditional mortgages change one or more of those features to give the borrower lower payments at the start, a more flexible schedule or easier qualification. Common types include interest-only loans, where the borrower pays only interest for an initial period such as five or ten years.
Others are option adjustable-rate loans that let the borrower choose a minimum payment which may be less than the interest due, and balloon loans, which have small regular payments followed by one large final payment. Some loans also relax the paperwork needed to prove income.
The attraction is cash flow. A buyer who expects a rising income, a bonus or a sale of another property may welcome low payments in the early years.
Investors and self-employed borrowers with irregular earnings sometimes value the flexibility as well. The danger is that the debt does not shrink as expected, or even grows.
If payments are lower than the interest charged, the unpaid interest is added to the balance, which is called negative amortisation, and the borrower can end up owing more than they borrowed. When the introductory period ends, payments usually jump, and a borrower who cannot refinance may face payment shock.
These products became notorious in the lead-up to the 2008 financial crisis, when many were sold to borrowers who could not afford the later payments. Since then, regulators in many countries have restricted or tightened the rules on them, and lenders must usually check that the borrower can afford the payment after the reset.
Anyone considering one should ask for a payment schedule showing the worst case, not just the first year. A sensible rule is to ask whether you could still afford the loan if rates rose, the property fell in value and the payments reset at the same time.
In practice
Real-world examples.
Example
A young professional expects her salary to double within five years and takes a $400,000 interest-only mortgage. She enjoys lower payments at first but plans to refinance before the interest-only period ends.
Example
A property investor buys a $750,000 apartment with a balloon loan. The payments are small for seven years, then a large lump sum is due, so he plans to sell the flat or refinance before the balloon date.
Example
A self-employed consultant with uneven income uses a lender that accepts bank statements instead of payslips. She pays a higher interest rate for the convenience and must have a plan for months when income is low.
Formula
Calculation
Interest-only payment = Loan balance x Annual interest rate / 12
A buyer takes a $300,000 interest-only mortgage at 6% a year. Monthly interest-only payment = $300,000 x 0.06 / 12 = $1,500. A standard 30-year repayment loan at the same rate would cost about $1,799 a month, so the interest-only loan saves about $1,799 - $1,500 = $299 a month. However, after five years of payments the balance is still $300,000, and when repayments start the borrower must pay off the whole $300,000 over the remaining 25 years, which raises the monthly payment above $1,799.Case study
Seen in the real world.
Larchmont Family is a fictional household invented to illustrate this idea. They bought a $500,000 house with an option mortgage that allowed minimum payments below the interest due, and they chose the lowest option for three years.
During that time, the loan balance rose from $450,000 to $468,000 because unpaid interest was added to the debt. When the option period ended, the monthly payment jumped by more than $700, and house prices in the area had slipped by 5%.
The family could not refinance because their balance was now close to the home's value. They cut other spending, sold a car and negotiated a repayment plan with the lender. The experience taught them to compare the full lifetime cost and the worst-case payment before choosing a loan.
Watch out
Common mistakes.
- Focusing only on the low starting payment. The balance may not fall, and the payment can rise sharply later.
- Assuming you can always refinance. If house prices fall or your income drops, a lender may refuse.
- Ignoring negative amortisation. Paying less than the interest due increases what you owe.
Questions
People also ask.
Are non-traditional mortgages illegal?
No. They are legal but regulated, and many countries require lenders to check that borrowers can afford the later payments.
Who might benefit from one?
Borrowers with strong, rising or irregular income and a clear plan to refinance or repay, who understand the risks.
What is payment shock?
It is the sudden rise in monthly payments when an introductory period ends or the loan starts to repay principal.
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