Nontraditional Mortgages: What You Need To Know Before You Apply

If you’re unable to qualify for a conventional loan or just aren’t interested in one, you may be wondering what other types of mortgages are out there. There are tons of options to choose from, many of which fall under the umbrella term of “nontraditional” mortgages.

What is a nontraditional mortgage, though, and is it the right choice for you? Read on for our guide to the different types of nontraditional loans and some of their benefits and drawbacks.

A nontraditional mortgage is a unique loan that doesn’t fit the requirements for a conventional or even unconventional loan. Nontraditional mortgages are usually easier to qualify for in terms of credit score and debt-to-income ratio (DTI) but can be risky for both lenders and borrowers. These mortgages tend to have unusual repayment terms and may allow borrowers to defer their payments or pay only interest until the end of the loan. It’s important to note that Rocket Mortgage® does not offer these types of loans.

Characteristics Of A Nontraditional Mortgage

Nontraditional mortgage loans are usually characterized by the following traits:

• They typically have a nonstandard amortization schedule.
• Repayment terms may be flexible.
• They're often riskier due to abnormal payment terms and lower credit score requirements.
• The loans are asier to qualify for than conventional loans.
• Interest rates may be higher for some borrowers.
• They may offer principal or interest deferral.
• They’re issued by private nontraditional mortgage lenders like businesses or home sellers rather than financial institutions.

Nontraditional Mortgages Vs. Other Types Of Loans

If the characteristics above don’t make much sense to you, don’t worry – let’s compare nontraditional mortgages to conventional mortgages to get a better idea of the differences.

With a traditional or conventional mortgage, the terms of repayment are fairly straightforward. To finance a home or property, you borrow some amount of money from your lender at an interest rate that is either fixed or variable. Then, you make payments toward the interest and principal you owe your lender until everything is paid off, after which you own the property outright.

With a nontraditional mortgage, these terms of repayment are a little different and give other options to home buyers who may not qualify for a conventional mortgage. Nontraditional mortgages allow borrowers that a conventional mortgage may not be right for. There are several different types of nontraditional mortgages, which we’ll discuss later, but the thing they each have in common is the option to get rid of the regular payment model in favor of a more flexible payment schedule.

This can be anything from paying only interest on a loan until the end when you’ll owe the full principal balance to gaining the ability to defer payments with little consequence, besides increasing the amount you’ll owe your lender in the end.

Nontraditional or Non-Conforming?

Nontraditional loans are often confused with unconventional or nonconforming loans. Nontraditional loans and non-conforming loans are not the same thing – though nontraditional loans are almost always non-conforming. So, what exactly is the difference, and how can a loan be both?

Non-Conforming loans

Non-conforming loans are any loans that don’t meet Fannie Mae and Freddie Mac’s standards for purchase, meaning they are not conventional. Many of them still operate like conventional mortgages in terms of repayment model and schedule, however, including mortgages such as FHA loans and VA loans. Even though you pay off an FHA loan the same way you would a conventional one, loans like these are considered nonconforming because they are government-backed and often have lower requirements for credit score and DTI.

Nontraditional loans

Nontraditional loans are loans that not only don’t conform to Fannie Mae and Freddie Mac’s standards, but also don’t have typical repayment schedules. Unlike FHA or VA loans, with a nontraditional loan, you may not even have to make payments every month. You might be paying only interest for a few years – or for the entire life of the loan.

There are three main types of nontraditional mortgage loans: balloon loans, interest-only mortgages and payment-option adjustable-rate mortgages (ARMs).

Balloon Loans

A balloon loan is a mortgage that operates on a lump-sum payment schedule. This means that at some point in the life of your loan, usually at the end, you’ll have to pay the remainder of the balance at once. Depending on your lender, you may pay only interest for the life of your loan and make one big principal payment at the end, or a combination of interest and principal, with a somewhat smaller lump-sum payment at the end.

With a balloon loan, you’ll have low monthly payments and the ability to use your money for other things, such as building credit or savings, before making your eventual lump-sum payment. These loans can be a good idea for homeowners that know they won’t be in a house very long or for homeowners that can actually pay the lump sum amount quickly to avoid having mortgage payments in the long run.

Interest-Only Mortgage

An interest-only mortgage is similar to some balloon loans in that it may allow a borrower to only pay interest on the loan for their monthly payment rather than interest and principal. Unlike a balloon loan, however, interest-only mortgages usually only allow you to pay interest-only for a set number of years. After that, your balance begins amortizing, which can greatly increase your monthly payment.

Most interest-only loans are ARMs, meaning your interest rate on the loan will be adjusted some number of times each year based on the current rates, causing your monthly payments to go up or down. These loans are often structured in the format of “5/6,” with the 5 being the number of years you’d pay only interest and the 6 indicating that your rate will be adjusted every 6 months.

There are interest-only fixed-rate mortgages as well, but they are very rare. ARMs can be more expensive long-term, so if a rate that is guaranteed not to increase sounds better to you, you may instead want to refinance to a conventional fixed-rate loan.

Payment-Option ARMs

A payment-option ARM adjusts monthly and allows borrowers to decide how they want to pay down the loan. Borrowers are given a number of payment options to choose from, including 15-, 30- or 4- year fully amortizing payments, minimum-and-over based payments, and even interest-only payments, similar to a balloon loan.

Payment-option ARMs can be very high-risk to borrowers, since there is a good possibility your monthly payments will increase and the amount of debt you owe may actually increase as well while you're attempting to pay it down, depending on your rate and how much over minimum you’re paying each month on the mortgage. These loans can be beneficial to those working with shorter-term investments but may prove too risky for homeowners seeking a good long-term loan.

Nontraditional mortgages have a reputation for being ‘riskier loans,’ but they can also be very useful to borrowers, depending on their situation. To see if a nontraditional loan might work for you, let’s review some of the pros and cons.

Pros

• Flexible payment options: Most nontraditional mortgages give you the opportunity to make lower monthly payments – or even pay off your entire principal balance in one lump-sum.
• They allow you to accumulate wealth before paying: One perk of being able to pay your balance off in full at a later date is that it gives you a chance to save money without making large monthly payments.
• You can afford a home faster: With loans like the interest-only mortgage, you can likely afford a home before you’d be able to otherwise since your monthly payments will be lower than conventional ones initially.
• You can pay off your loan faster, too: With an interest-only loan, if you make payments toward your principal on top of the monthly interest, you’re lowering the amount you’ll have to pay off later. Nontraditional loans are often short-term, too, so if you can afford to pay the lump sum at the end of a balloon loan, you could rid yourself of mortgage payments that way, too.

Cons

• Potentially high interest rates: Not all nontraditional loans have high interest rates by default necessarily, but many of them are ARMs and have the potential to increase your rate at any time. Since many nontraditional mortgages also have less strict credit and DTI requirements, your rate may be higher to account for the risk of you defaulting on the loan as well.
• Greater risk of defaulting: While flexible payment options can be very useful, they can also be dangerous to borrowers. On some of these nontraditional loans, if you make only minimum payments or defer your payments, the amount you owe your lender could actually increase. If your monthly payment climbs too high, you may no longer be able to afford to pay it.
• Housing prices could fall: If you have an interest-only loan and plan to sell your home before the interest-only period ends but the value of your home falls drastically, you may be unable to sell your house and could get stuck with a much higher payment and forced to default on the loan.
• No equity: With many nontraditional loans, the option to pay only interest is great because it allows you to make lower payments – but you aren’t building any equity in the home. If you have to sell your home with little to no equity, you may end up making nothing or even paying to sell.

Nontraditional mortgages offer lower monthly payments and flexible payment options and typically have less strict requirements to qualify for them than conventional loans, which makes them very attractive. These loans can be useful if you need financing for a short-term investment or have another unique situation that calls for an initially low-cost nonconventional loan. These flexible options, however, can be dangerous to borrowers, especially when paired with higher rates.

Before deciding to get a nontraditional mortgage, be sure to do your research and determine whether the loan would be a good option for you even in a worst-case scenario where your monthly payment increases by a sizable margin.

Nontraditional loans are an option for borrowers in need of unique financing to suit their needs, but these loans come with risks as well that you should consider before seeking one out.

If you are exploring your mortgage options, check out our guide to getting a mortgage even if your credit isn’t the best or apply for a mortgage online today to see what traditional loan options might be available to you.