My last blog post was on adjustable rate mortgages, or ARMs.  If there's one type of ARM that is receiving scrutiny right now, it's the Deferred Interest ARM, aka Negative Amortization, NegAM, Pick-a-Payment, OptionARM, PayOption...

This is one of the most popular home loans, but it's not well understood.  When you hear a news report saying that foreclosures are rising because of "exotic" loans, this is near the top of that list.

You've heard commercials for this loan, or, if you live in California, you get three to four advertisements in the mail every day promising a low interest rate...say 1%.

Sounds great right?  Or is it?

 The evil NegAm?

Here's what the commercials don't tell you: that interest rate lasts about, well, one month.  After that it becomes an adjustable rate. 

Why in the world would anyone want that type of loan?

Well, there are some good reasons.  Here's a secret: this is the type of home loan that I have.  Before I explain the allures of the OptionARM, first let me explain how the typical NegAM works (NOTE: There are many different kinds of Deferred Interest Loans, but I'm going to describe the basic one to simplify)

Let's say your starter rate is 1%.  The reason it's at 1% isn't to trick you into thinking you have the most amazing home loan ever.  The interest rate that you start with is meant to set your monthly payment.

The typical OptionARM has a minimum payment.  That's the payment at 1% (or the starter rate).  For your first month or so, this would pay all your interest and reduce your principal.  The interest rate may change after the first month, but the minimum payment changes after 1 year...typically once per year there is a slight adjustment.

So what happens when your interest rate changes?  Well, now you have the Option:  Do you pay the minimum payment, the interest only payment, the 15, 30 or 40yr payment?

Now that the interest rate has changed, that minimum payment won't be enough to pay down your principal.  It won't be enough to pay all the interest.  Voila!  Deferred interest, or negative amortization.  Your loan balance just increased by the amount of interest you're deferring. 

That all sounds very scary.  Before it gets better, it gets worse!

Typically your OptionARM can only grow to 115% of the original balance.  Then it recasts.  Recasting means this: now you don't have the loan payment options that you had at first.  Now you have to pay the principal and interest payment for the remainder of the term.  For example, you pay only the minimum on a $100,000 loan, andyour interest rate goes up, and after 3.5 years or so the loan balance has increased to $115,000...boom...the loan recasts and you have a minimum payment of Principal and Interest amortized over 26.5 years.  It's a much bigger payment then the 1% starter rate.

If you got the OptionARM because you really wanted the house you couldn't afford, now you can't make your payments at all.  If you didn't put money down, or if your home has depreciated, now you can't even sell the home and you're headed to foreclosure.

Right now you're either thinking, OMG Joey...Why do you have that loan?!

Or you're thinking, OMG Joey...why do I have that loan?!

Here are some benefits of a NegAm:

• If you're a commissioned salesperson, this type of loan is very useful when you have a slow month.
• If you own your own business, this loan gives you the most cash flow.
• The rate cap is typically at 9.95%...lower than many other ARMs (3-, 5-, 7-, or 10-year fixed)
• If you plan on moving or refinancing from 1 to 5 years down the road, a fully amortized loan isn't going to pay down much principal anyways.

Here's an example how my clients have used a NegAm:

A couple came to me to refinance.  Their goal was to lower their monthly payments so that she could stay home with the kids instead of work.  They have plenty of equity, and she will probably return to work in 3-5 years when her children are all in school.  They couldn't afford a fully amortized loan if she quit.  What could they do?  They could sell the house and downsize.  OR...

They refinanced into an OptionARM and pay the minimum payment.  There's not much risk, even if they pay the minimum payment.  Their loan balance might grow 8-10% before she retures to work, and being aware of that is important.  But they decided that it was a better decision to spend some of their home equity, a little at a time, rather than pack up and move.  They reviewed the risks and it made sense.

Probably the biggest field of growing OptionARM borrowers use the NegAm to build wealth.  The short explanation is this: do you need more equity in your home, an appreciating (over time) asset?  Do you really want to get rid of the largest (perhaps) tax deduction you have (your mortgage loan)?  Or is your money better spend investing in other appreciating assets? 

The trick to this is that you have to be very disciplined...and that's why I wouldn't recommend this loan to just anybody.  You have to know yourself, the risks involved and have a plan if you have this type of loan.

Do you have a broken ARM?  Or does your NegAm work for you, like mine is working for me?