Don’t be seduced by a low payment into taking a loan that you may not be able to afford in the future.
- Know the pros and cons of a neg-am loan.
- Consider your cash flow needs.
- Review the loan examples below.
Don’t be seduced by a low payment into taking a loan that you may not be able to afford in the future.
Amortization is the gradual decrease of the principal balance of your loan over time. Negative amortization reverses the process—your principal balance gradually increases because your monthly payment is smaller than the mortgage interest you owe each month. The principal balance of your mortgage is the amount you borrow—your loan amount; the cost of borrowing that money is the monthly mortgage interest you pay.
There are two types of negative amortization loans. Option ARMs have an interest rate that adjusts every month, and a low minimum payment that changes annually. This minimum payment increases only slightly each year no matter how high the interest rate is on the loan. Hybrid Neg-am loans have a relatively high interest rate that is fixed for five or seven years, but a low payment that is also fixed for either five or seven years. This fixed payment is based on an interest rate several points lower than the loan’s interest rate.
When shopping for a ’neg-am’ loan, buyer beware. There are many conflicting opinions about which loan is the best, and lenders are always adding attention-seeking bells and whistles—1.25% rate! with 5-year fixed at 4.25%!! Remember, if it looks too good to be true, it probably is.
Much like the car industry, lenders create a product, price it for profit, then market it aggressively—adding enticing marketing hooks: a very low starting interest rate (for one month), a payment fixed for five years at a low rate (with the loan balance increasing by 15% over the five years), no points (but with a large prepayment penalty).
One way to get the advantages of neg-am is to have a an interest-only mortgage with the rate fixed for at least seven years, combined with a home equity line that you draw down slightly each month to help pay your mortgage payment, making it more affordable. Although your principal balance is still increasing, this gives you the cash-flow benefit of a neg-am, while giving you a low fixed interest rate for your first mortgage.
Option ARMs have an initial ‘teaser’ interest rate, usually good for one month, setting a low initial payment. This is your minimum required payment. Option ARMs have an annual cap on the minimum payment—not on the interest rate—that allows the payment to increase by only 7.50% per year. For example, a payment of $1,000 in year one would increase to $1,075 in year two. However, after the first month—not year—the interest rate on the loan adjusts upward dramatically, generating a new, sharply higher payment. You have the option of continuing to make the initial, lower payment. The difference between that initial teaser payment and the new interest-only payment based on the higher rate is added to your principal balance. Your principal balance gets bigger every month; how much bigger depends on how high your interest rate is at each monthly adjustment.
Let’s use as an example a monthly adjustable neg-am loan with start rate of 1.00%, and a margin of 2.35% over the 12-Month Treasury Average (MTA) on a loan balance of $500,000. The base payment at the start rate of 1.00% would be $2299. This rate and base payment are both good for one month. At the end of the first month the loan will be fully indexed; let’s say that at the beginning of month 2 the index is at 4.827% (where it is in November of 2006) so in month 2, the new rate would be 7.187% [4.827% (index) + 2.35% (margin) = 7.187% (fully indexed rate)], and the new interest-only payment would be $2994; with interest and principal the payment would be $3390.
At this point you have three options: pay the new interest-only payment, $695 more than the minimum, or pay principal and interest, $1091 more than the minimum. Or, you can continue the original payment of $2299, and have the difference between that payment and the interest only payment, $695, added to your principal balance. This continues, with monthly adjustments in your interest rate and payment to reflect any change in the index, until the end of the first year. Then, because of the payment cap, the original base payment (not the interest rate) increases by only 7.50%, or from $2299 to $2471. Meanwhile, each month your payment is refigured based on that month’s index plus your margin. Remember—each month you make that minimum payment your loan balance is increasing, and your new payment each month is figured on that new, higher, balance. If the loan went to its life cap, the interest-only payment would be over $4000 each month—a lot more than the $2299 that you signed up for.
Also called fixed-pay ARMs, hybrid 5-year or 7-year fixed neg-am loans have a payment based on an interest rate that is 3.00% or more lower than the loan rate. If the loan rate is 7.25%, your payment will be based on a rate of 4.25% or lower. Guess which rate the lenders advertise when they are trying to sell you on the loan? The negative amortization will be at least 3% of the loan balance each year; this means that on a $500,000 loan your principal balance would increase by at least $15,000 per year. See the detailed example to compare doing a negatively amortizing 5-year fixed to one that has an interest-only payment.
We’ll use a 5-year fixed neg-am loan of $500,000 with a payment based on 4.25%—that would be $1,770—and an interest rate fixed at 7.25%, which would have an interest-only payment of $3,020. So, if you make the minimum payment of $1,770, you would be adding $1,250 per month to your loan balance ($3,020-$1,770), or $15,000 per year, or $75,000 over the five years of the loan. Again, at the end of five years you would owe $575,000.
The other necessary piece for this example is the interest rate on a 5-year fixed interest-only loan that has no negative amortization, which is going to be about 1.00% lower in interest rate—for this example 6.25%, which would have a payment of $2,604. If you got the 5-year fixed with no negative amortization at 6.25% and made the $2,604 payment your total of payments over the five years would be $50,000 more than if you had made the $1,770 payment ($2,604-$1,770 X 60 months), but your loan balance would be $500,000, not $575,000. Even though the neg-am payment was $834 lower than the payment on the fixed, at the end of five years the neg-am loan would have cost you $25,000 more.
