There are many different mortgage options available to homeowners. A traditional 30-year fixed-rate mortgage is no longer a consumers only financing option. There are monthly-adjusting variable-rate mortgages, fixed-period adjustable-rate mortgages (ARMs), 3-2-1 buy-downs and payment-option ARMs, just to name a few. (To find out more about mortgages, see Shopping For A Mortgage, Understanding The Mortgage Payment Structure and Investing In Real Estate.)

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As is the case with most financial decisions, there is typically a tradeoff between risk and reward in the choice of a mortgage. In this article, well take you through the process to make your own risk-based mortgage decision.

Know Your Mortgage

An adjustable-rate mortgage, for example, might offer low initial monthly payments based on current interest rates, but the monthly payments have the potential for substantial increases in the future if interest rates rise. A payment option mortgage can offer very low initial monthly payments when deferred interest is added to the principal balance of the mortgage, but triggers exist that could cause the monthly payments to suddenly rise. A homeowner would likely face serious financial difficulty if home prices fall while the mortgages principal balance rises. The key to making a sound financial decision regarding the choice of a mortgage is to both identify and measure the risks associated with that mortgage and to then ask the questions, Are the risks worth the reward? and Can the risks associated with a bad outcome be tolerated?

Two Primary Measures of Mortgage Risk

There are two primary risks associated with the choice of a mortgage that should be identified and measured: the risk of payment shock and a mortgages effect on home equity.

Payment Shock

Payment shock is the term used to describe the potential for substantial monthly payment increases. Payment shock is generally associated with adjustable rate mortgages. It is the result of the expiration of a temporary start rate or fixed-interest rate period, an increasing fully indexed interest rate, the end of an interest-only payment period or the recasting of a payment option arm minimum payment.

All adjustable-rate mortgages carry some risk of payment shock. Many have the features mentioned above, which add to this risk. For example, 3-2-1 or 2-1 buy-downs offer a schedule of initial temporary start rates; as those start rates expire, the monthly payments increase. Fixed-period ARMs have a fixed interest rate for some period of time, usually three, five or seven years. As the fixed-rate period expires, the monthly payments are likely to increase.

Interest-only mortgages can offer lower initial payments because the monthly payment consists of interest only; when the interest-only period expires, the monthly payment will increase. Some mortgages, such as so-called payment option ARMs, offer very low initial monthly payments, but also have triggers that can cause the payment to increase substantially. (To keep reading about ARMs, see American Dream Or Mortgage Nightmare. ARMed And Dangerous and Mortgages: Fixed-Rate Versus Adjustable-Rate.)

Home Equity

Home equity is a measure of the net worth of a home to the homeowner. The creation of home equity builds wealth and opens up additional financial benefits and financing options. However, the destruction of home equity can also severely limit future financing options.

Understanding a mortgages probable effect on home equity over a planned time horizon is important to future financial considerations. A primary risk measure used by lenders is the size of the mortgage relative to the value of the property. This is known as the loan-to-value ratio. If home equity is destroyed, the loan-to-value ratio increases. This can make it harder to refinance out of an existing loan, require that new financing be done at a higher interest rate, require the payment of private mortgage insurance, or necessitate the use of a different type of mortgage. In a worst-case scenario, if the value of a home drops below the remaining principal balance of a mortgage, all financing options are effectively eliminated. (To keep reading on this subject, see Mortgages: How Much Can You Afford. Paying Off Your Mortgage and Digging Out Of Personal Debt.)

In traditional lending, part of each months mortgage payment is applied toward the principal balance of the mortgage according to an amortization schedule. However, many new mortgages that have become popular in recent years offer such features as interest-only payments, or even payments that are less than the interest-only payments. When an interest-only payment is made, the remaining principal balance of the mortgage remains constant. When a payment that is less than the interest-only payment is made, deferred interest is created. Deferred interest is then added to the principal balance of the mortgage. This is known as negative amortization. The principal balance of the mortgage actually increases! When the principal balance of a mortgage remains constant or increases, home equity can remain constant or might be destroyed, depending on the rate of home price appreciation. Because home equity plays an important role in future financing considerations, the rate of home equity creation should be a major part of any mortgage decision. This is especially true for interest-only and negative-amortization mortgages because most borrowers choose these loans with the intent to refinance out of them within a certain time horizon.

Making Estimates

Properly measuring the risks of payment shock and home equity inherently requires making estimates of future interest rates and home price appreciation. These estimates should be based on a most likely or probable outcome. They should not be solely based on best- or worst-case scenarios. These calculations can be made for mortgage payments and home equity.

Calculating Home Equity

Home equity is a function of two things: the rate at which the market price of a home appreciates or depreciates and the remaining principal balance of a mortgage. (Home equity equals the homes value minus the mortgages principal balance). The rate at which homes appreciate or depreciate varies from state to state, town to town, and even from neighborhood to neighborhood within the same city. There is no single, infallible way to make an estimate of future home price appreciation. However, recent past performance and a tendency for appreciation rates to revert to their long-term averages provide some guidance. For example, if a home appreciated 10% in the preceding year, but the long-term average is 5%, 7% might be a good estimate for the next year (6% might be a good estimate for the year after that, and 5% is a good estimate for the remaining years).

The simplest way to calculate future home values based on estimates of price appreciation is to use a spreadsheet where the value of the home in each month equals the value of the home in the preceding month x (1 + (estimated annual appreciation rate / 12)). Note: this method uses monthly compounding of an annual rate, which means the annual appreciation calculated will be slightly larger than a simple annual calculation. (To find out more about compounding, see Overcoming Compoundings Dark Side and Understanding The Time Value Of Money.)

Calculating Future Monthly Payments

Calculating the future monthly payments of some mortgages can be quite difficult because it involves estimates of future interest rates, which must be applied to the embedded interest rate structure of the mortgage, such as initial, periodic and lifetime interest rate caps, as well as negative amortization limits and temporary buy-downs. Many tools exist on the web to help. The key, as mentioned above, is to use reasonable and probable estimates of future interest rates.

History has proved that while no method of forecasting future interest rates is entirely accurate, the best estimate of future interest rates is a consensus of market opinion. The markets opinion is best reflected in the shape of the yield curve. Therefore, when using a web-based calculator to calculate future mortgage values, it is suggested that the course of future interest rates be determined by the shape of the yield curve. For example, if the index to which an ARM is tied currently stands at 6%, and the three-month T-bill yield is 5%, while the two-year Treasury note yield is 6%, we can assume that the index to which the mortgage is tied will increase by 1% (the spread between the three-month T-bill and two-year Treasury notes) in the next two years.

Measuring Values and Identify Risks

Home equity calculations can be made in the same manner. The remaining principal balance values calculated using the web-based mortgage calculator can be subtracted from the future home value estimates made as described above under the Calculating Home Equity section. Varying estimates of future home price appreciation can be made and measured against the most probable outcome.

Conclusion: Making a Risk-Based Decision

With a spreadsheet showing and comparing a schedule of a most probable monthly payment scenario against varying monthly payment scenarios, and a similar analysis of home equity scenarios, an effective risk-based mortgage decision can be made.

The following important questions can be asked and answered in an educated, risk-based manner.

Monthly Payment Scenario

Understanding that the most probable monthly payment scenario is an estimate, but having the ability to measure varying monthly payment scenarios against it, is the risk of choosing mortgage x worth the reward, and can the risk of a bad outcome be tolerated should it happen? In other words, I like the initial low monthly payment, but is having it now worth the risk that it could increase substantially in the future, and if it does increase, will I be able to meet the payment without stressing my financial situation?