Mellody's Math: Zero-Percent Financing

Although an option ARM can be useful for borrowers who have different amounts of cash flow each month (i.e., those with commission-based salaries), it can also be extremely risky for several reasons. First, you will not build equity in your home if you consistently pay either the minimum or interest-only option. In addition, these loans can be risky for those on a tight budget who cannot handle the impact of interest rate fluctuations. Another potential issue is that if the value of your home does not rise, you could owe more than the home's value when you sell the property -- again, a dangerous proposition for those who live paycheck to paycheck.

Mellody's Tip: The Downsides of the Minimum Payment

With the minimum payment option, generally, the amount you pay will not pay down any of your principal balance and will not be enough to cover the amount of interest charged on your loan for that month. As a result, you will be deferring unpaid interest, meaning it will be added back to your loan balance, resulting in negative amortization (i.e., your loan balance increases). This can be a very slippery slope if you consistently pay just the minimum amount. In fact, for a borrower who only makes the minimum payment each month, the default rate is likely to be 20 percent higher than on a traditional mortgage. That said, the minimum payment option will be removed if the loan balance increases to a certain level above the original loan amount -- usually between 110 percent and 125 percent.

Know Your Needs and Your Limits

Although creative financing is boosting home ownership, pocketbooks are often being stretched too thin. As always, prospective buyers should assess how much they can comfortably afford and how long they plan on staying in their home when determining which mortgage option is right for them. You also need to carefully weigh the benefits and the risks with your own personal situation in mind. That said, with interest rates still at low levels, fixed rate mortgages and traditional ARMs offer consumers the best options with the least amount of risk.

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