Negative Amortization, what is it and how does it affect me?

In recent years there has been a lot of controversy surrounding the Option Arm loan (aka Negative Amortization or "Neg. Am." loan). Some of the stories we've heard would almost have you believe that the loan was a living and breathing thing that devours homes and people alike. Like all loans, the Option Arm has its niche client that it serves the best.

First off let me briefly explain how the Option Arm loan works. There are three main components to any Option Arm loan the Index the Margin, and the Start rate.

The index can be anything we use as a base measurement. Banks use the cost of their funds as a base measurement. All indices are variable, which means they have the potential for movement up or down in any given month. There are many indices a bank can use, but three are generally accepted as the most stable indices in the lending world: The 11th District Cost of Funds Index, also known as COFI; the London Inter-Bank Offertory Rate better known as LIBOR; and the 12-Month Treasury Average, also known as the 12 MTA.

The margin is locked in for the life of the loan. This is the lenders profit margin. By adding the margin, together with the index, we get what's called the fully indexed rate. This is the interest rate that the bank is charging you on your loan. The one thing to note here is that, no matter what happens to the index on a monthly basis, the banks profit margin is always guaranteed.

The start rate. This is the most confusing component of the Option Arm loan, either because it is not explained properly, or because people just don't ask any questions regarding how the start rate works. The start rate is a percentage used only for figuring out a beginning payment. Generally banks offer a 1% start rate. The actual number is unimportant. The point is that the start rate is used to figure out a payment only. Once the loan starts, the bank will charge you the fully indexed rate, but your payment will stay at the start rate. The difference between the starting payment and the full interest payment is called Negative Amortization and it is added to the balance of your loan to be paid at a later date. How much later? That's up to you! Here is the beauty of this loan -- the bank gives you 4 payment options every month: 1) the minimum payment; 2) the full interest payment; 3) the full 30-yr principle and interest payment; and, 4) the 15-yr full principle and interest payment. The deferred interest can be paid any time you like.

The Option Arm loan is not for everyone. It was originally devised so that clients with flexible incomes could qualify for a more expensive home, based on minimum payments. People whose income is derived from commissions, or perhaps augmented considerably, through a quarterly or yearly bonus of some sort, have the convenience of making a minimum payment for as long as they need to, knowing that at certain times of the year they can put down a substantial amount of money towards interest that has accumulated on to their principle balance.

The people who this loan is definitely NOT for are those that are salaried, or topped out on their income, and can only afford the minimum payments. This group of borrowers was hit the hardest in the last few years, mainly because some mortgage broker talked them into, or sold them on the minimum payment. They were then brainwashed into believing that the value of their home would continue to rise, and therefore their equity would grow, essentially having them bet on the come line (to use a gambling metaphor). These buyers believed that as long as the value of their home kept rising they could make the minimum payment and still stay ahead of the deferred interest. Unfortunately, that's not how things worked out.

Like I mentioned earlier, Neg. Am. loans do have their niche. If disciplined enough, one can use this loan as a strategy for building wealth or for maximizing cash flow. It can also be good for the first-time home buyer who has plenty of time to concentrate on paying the mortgage down later, right now they have a house to personalize with landscaping, window treatments, pool, etc. The option to defer interest allows them to stay in the '''banks good graces, while keeping more money in their pockets.

Unfortunately too many people end up getting used to making the minimum payment only, and start spending the extra cash permanently, by way of incurring fixed debt instead of temporary debt. Car payments, charged up credit cards, boats, vacation homes and the first thing everyone says is, "I got one of those awful Neg. Am. loans". You know, the ones that force you to spend all your money on other things besides your mortgage. Come on folks! That's like saying, "I bought one of those Mercedes Benz. You know, the ones that force you to get car jacked".
How about some responsibility on the part of the broker or the consumer for that matter. I definitely believe that we have a duty as mortgage professionals (see last week's blog on Fiduciary Duty), but in this case the consumer also has to exercise a little restraint.
Neg. Am. loans have helped many of my clients build wealth by diverting stagnant equity into a compounding tax-free investment vehicle that could help them increase their net worth. Others have used this loan for rental properties to maximize their monthly cash flow, or to help them offset the effects of a temporary vacancy. So you see, the Neg. Am. loan is just that, a loan. One of many loan programs that your mortgage professional should educate you about so that you can make an informed decision about what type of loan is going to serve your needs best. If I can help find the right loan for you, please call or email me today. - Ernie.