Top 5ive Mortgages to Avoid

SHOPPING AROUND FOR a mortgage is nothing short of confusing. Thanks to plenty of innovative products on the market, a consumer has more than 50 loans to choose from. "While there is a mortgage out there for everyone, not every mortgage is right for every consumer," says Mark Lefanowicz, president of E-Loan, an online lending site. And now that the real estate market is softening, there's no guarantee that home prices will continue to appreciate — at least not over the next few years. So buyers need to be particularly wary and not take on additional risk.

Here are five popular, yet risky, loans that the average consumer should avoid.

1. The Multiple-Choice Mortgage

Product: The Pay-Option Adjustable Rate Mortgage (ARM)
Why You Should Avoid It: Could end up owing more than you borrowed.

This is considered the riskiest mortgage around. The pay-option ARM offers borrowers a low initial interest rate and then allows them to choose one of four monthly payments. On the more conservative side, homeowners can opt to write a check for both the interest and principal on a fully amortized loan. On the other end of the spectrum, borrowers can make a payment that's so small it doesn't even cover all of the interest due on the mortgage.

While some advocates argue these mortgages are good for people with modest salaries but large bonuses — think Wall Street — many average home buyers are taking advantage of them, too. And that spells trouble. It's simply too tempting to make that minimum payment when families have others bills to pay off. The risk? In just a few months a homeowner could find he's "upside down" in his loan, warns E-Loans Lefanowicz. That means he owes more to the bank than he initially borrowed.

2. Cash-Out Financing

Product: 103s, 107s, and 125s
Why You Should Avoid Them: Can't count on home appreciation to build equity.

Think of it as easy money. Lenders now allow homeowners to take out a mortgage for more money than a home is actually worth. Consumers can borrow an extra 3%, 7% and even 25% of a property's value to help fund closing costs and renovations or even pay off credit-card debt.

Here's the rub: If a home doesn't appreciate in value enough to cover the total amount of the loan, a homeowner could end coughing up the extra cash to pay off the mortgage upon moving. This wasn't considered too risky a few years ago when the real estate market was hot and home prices were moving higher by the day. Now, however, all data point to a softer market with fear of a correction ahead, says Celia Chen, director of housing economics at Economy.com. As for interest rates, borrowers should expect to pay through the nose. Lenders will often charge 50% more for one of these highly leveraged products, says Lefanowicz.

3. Adjustable Rate Mortgages (ARMs)

Product: One-Year and Three-Year Fixed-Rate ARMs
Why You Should Avoid Them: Tough on budgets, since the monthly payments are variable in just one to three years.

Call this the high-risk, little-reward mortgage, at least in today's rising interest rate environment. Here's how they work: Borrowers lock in a slightly lower interest rate for the first one to three years. The product then readjusts every year in tandem with highly volatile short-term interest rates. Since 2004, the one-year ARM has increased two percentage points to 6% from around 4%. That means a homeowner with a $300,000 mortgage is now paying $4,400 more a year than when he first took out his loan.

A few years ago, these loans appealed to consumers who needed a little extra help making their monthly payments during the first few years of homeownership. But now, there is only a half a percentage point difference between the interest rate on the 30-year fixed and the one- and three-year ARM. While that discount might still appeal to some homeowners, the risk of that mortgage readjusting upward is too great to justify the minimal savings, says Keith Gumbinger, vice president of HSH Associates Financial Publishers. Better to lock in the interest rate on a 30-year fixed-rate product and never think again about what the Federal Reserve will say at its next meeting. (Click here to compare payments on a fixed rate mortgage vs. an ARM.)

4. Interest-Only Payments

Product: Three-Year, Five-Year, Seven-Year and 10-Year Interest-Only Option on an ARM (Commonly referred to as the Interest Only Mortgage)
Why You Should Avoid Them: Monthly payments can quickly balloon.

Can't afford a home in today's pricy environment? A mortgage that gives you the option to pay just the interest on a mortgage offers consumers yet another way to slash their monthly payments. As the name implies, borrowers don't pay down any principal for the first three, five, seven or 10 years of their loan.

Now it's time to read the fine print. After the initial "interest only" portion expires, the monthly payments balloon to cover the remaining interest and all of the principal payments on that mortgage. Borrowers are also charged a slight premium on their interest rate, compared with fixed-rate ARMs, since people who take on these loans are more likely to go into default. Add it up and the new payment is likely to break the average family's budget, especially if they could only afford the interest portion to begin with, warns HSH's Gumbinger. At this point many borrowers will either have to spend a few thousand dollars to refinance or sell the house.

5. Fixed-Rate Loans

Product: 40-Year and 50-Year Fixed-Rate Mortgages
Why You Should Avoid Them: Builds equity too slowly.

As the name implies, these long-term vehicles are mortgages that amortize over a period of 40 or 50 years. The selling point is that a homeowner could lower his monthly payments by stretching out the terms of the loans. But when you do the math the savings just aren't that significant. On a $300,000 mortgage, a borrower would reduce his monthly mortgage payment by roughly $80 with a 40-year vs. a traditional 30-year fixed rate mortgage.

What does a homeowner have to sacrifice for that minimal monthly savings? It will take significantly longer to build up any equity in a home compared with a 30-year mortgage, says Lefanowicz. Consumers will also pay a lot more in interest over the life of the loan since the interest rate is typically a quarter of a point higher than the more traditional alternative.