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Business Week has a fascinating story about “nightmare mortgages” — adjustable rate home loans made over the past few years that now haunt consumers.

For cash-strapped homeowners, it was a pitch they couldn’t refuse: Refinance your mortgage at a bargain rate and cut your payments in half. New home buyers, stretching to afford something in a super-heated market, didn’t even need to produce documentation, much less a downpayment.

Those who took the bait are in for a nasty surprise. While many Americans have started to worry about falling home prices, borrowers who jumped into so-called option ARM loans have another, more urgent problem: payments that are about to skyrocket.

When we bought our current home in the summer of 2004, we briefly considered an adjustable rate mortgage. Fortunately we were surrounded by good advisors, all of whom warned against it. Not everyone is so lucky.

In February [Gordon Burger] got a flyer from a broker advertising an interest rate of 2.2%. It was an unbeatable opportunity, he thought. If he refinanced the mortgage on his $500,000 home into an option ARM, he could save $14,000 in interest payments over three years. Burger quickly pulled the trigger, switching out of his 5.1% fixed-rate loan. “The payment schedule looked like what we talked about, so I just started signing away,” says Burger. He didn’t read the fine print.

Burger’s story illustrates three key points:

  • Read the fine print of any contract you sign. Burger gave up a 5.1% fixed rate — which is mind-boggling — for a nightmare loan. It’s a mistake that will cost him dearly.
  • If something seems too good to be true, it probably is. Make sure you’re comparing apples to apples. Make sure you fully understand the consequences of a purchase.
  • Never buy any loan based on the minimum payment. This is true not only for mortgages, but also other loans as well (especially car loans). The minimum payment is the least important concern.

“Nobody reads everything they sign,” you may say. But it’s not true. Some people do read contracts completely, or pay somebody else (their attorney, for example) to do so. My wife and I read all short documents thoroughly. We don’t read mortgage documents for every minute detail, but we both scan them, looking for anomalies. It takes us a long time to sign mortgage documents, but so what? This is the most important financial decision of our lives; it should not be rushed.

This is a vital skill. I’ve walked away from various contracts because I didn’t like the terms.

Even so, I sometimes make mistakes. When we bought this house, I picked up a home equity line of credit to finance some lingering debt. This is now my last outstanding loan, and it’s a thorn in my side: $19,000 with an adjustable interest rate. Over the past two years, the interest-only minimum payments have risen from about $90 to about $160. I pay more than the minimum each month — and year-end bonuses are all earmarked for this loan — but I still feel overwhelmed. It must be terrible for somebody whose entire mortgage has undergone this transformation.

Banks continue to push ARMs because they’re profitable, and because they can use accrual accounting to claim future profits today. Lenders offer mortgage brokers — who write 80% of all mortgages — better commissions on ARMs to promote their sale. Banks are in the game to make money, not to help you. You need to look out for yourself. (Beware of 50-yhear mortgages, too.)

Though there are advantages to homeownership, it’s not for everyone. If you’re going to buy a home, do it right. Get professional advice. Don’t buy more than you can afford. And remember that sometimes renting is a better option.

If you’d like to read more on this subject, C.P.A. Brian Brown has a couple of articles that may be of interest: Interest-Only Loans = Financial Prison and a series on Real-Estate Taxation and Other Insights.

[Business Week: Nightmare Mortgages — the article is long, but it's an excellent read]