Real Estate Investor: The Downsides of Balloon and 1% Downpayment Mortgages

Because of the Fed rate hikes of the past few months that have seen average thirty-year mortgage interest rates go from around 3% per year to the current 7.5% per year, very few people want to sign up for home mortgage financing. Also, current homeowners who would have wanted to sell and move elsewhere are dissuaded from doing so because they prefer to keep their 3% locked-in rates on their thirty-year mortgages, than sign up for the higher ones. Hence there is very little movement right now.

In order to survive and generate business, some developers are offering balloon-type mortgages and 1% downpayment mortgages. As a real estate investor, let me give you some in-depth information about these options.

In balloon-type mortgages, a buyer can have a very low monthly payment scheme for the first few years, but then needs to pay a big lump sum after that grace period has elapsed. The problem is if the buyer enjoyed the grace period but doesn't really have the discipline to save up for the lump sum payment. Then that ends badly as a foreclosure.

As stated, the 1% downpayment mortgage only requires a 1% downpayment. Then the developer or seller contributes an additional 2% to get the total downpayment up to 3%. Seems like a good deal, but in reality, it's still better to save for a higher downpayment if considered from a long-term perspective.

Although owning a home is how most people grow equity and build wealth, the current situation requires some careful thought. Both are not really optimal options. Usually, the best option for a prospective buyer is still to save as much as possible for a larger downpayment so that the loan portion is smaller. Remember that, although very few buyers can do this, the cheapest way to buy a house is to negotiate with the seller when you have the cash. The larger the loan amount, and the higher the interest rate, the more a buyer ends up paying.

Many of us accumulated personal savings during the pandemic from government cash gifts from the CARES Act and the fact that we mainly just stayed at home and didn't have much to spend on. That personal savings has been depleted as we attempted to normalize our lives and have been replaced by increased debt spending, a lot of it on credit cards. Credit card debt has ballooned to over a trillion dollars. Add to that the fact that those who have student loans will restart payments in October 2023. For a lot of us, taking on a 7.5% mortgage at this time in this situation is not a good strategy.

Also, consider the fact that average home values in some areas (not all) have been declining slightly since June 2023. Note that average does not mean that the house being considered will decline in price. It just means on a national average, there is a slight decline. So if a buyer takes on a large loan for a house on high interest whose price is losing value, then they are losing money.

When someone buys a house, they will be responsible for all property taxes, insurance, and home repairs. While renting is purely an expense, it is the landlord who takes care of all these costs. Plus when the mortgage rate is high, a lot of their payments really just go into servicing those interest payments and not the principal loan for the home. Sometimes the best way to buy a house is to rent first, save as much as possible for a downpayment, then when the interest rates look better and a buyer has found the house they really like, that's when to pounce.

What a buyer really needs to do is sit down with a financial adviser or use a reliable mortgage calculator to figure out how much each option will cost. Each buyer needs to figure out how much they can comfortably afford to shell out for mortgage payments each month.

A good percentage to aim for is around 30% of their debt-to-income ratio. That means that if a buyer pays 30% of their take-home income for their mortgage, the remaining 70% will go towards other bills and discretionary spending. Anything higher than 30% becomes too stressful for many people and increases the chances of foreclosure and damage to your credit rating.

On the other hand, young people who have good jobs often end up spending a lot on items they don't really need or even use. Their spending sometimes is really just so they can. In those cases, if they can muster the discipline, they can save up for a large downpayment, then try to pay off the loan as early as possible. In that way, they don't waste the fruits of their labor on useless purchases. Instead, they are able to save and build wealth by buying a house early.

Owning a home is still one of the best ways for most people to grow equity and build wealth. However, sometimes the best road to go somewhere is not the straight one. Sometimes renting first and saving for that larger equity downpayment while waiting for lower mortgage rates is the better option. That is if people have the discipline to save for a downpayment and not splurge it somewhere else.

Note that no one can predict the future and say with certainty that mortgage rates will go higher or lower next year, or the year after. But it is still a better option to try and save for the biggest downpayment you can muster while doing that instead of instantly signing without careful thought to those balloon and 1% mortgage contract agreements.

The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.