The Pro's and Con-Artists of Negative Amortization

How many of these have you heard of? Pay-Option Arm, Potential for Negative Amortization, Pick-a-Pay, Half Loan, Neg Am, Four-Pay, and the loan that costs me less than a cell phone bill.

Let’s go through the technical stuff first;

Generally, the payment option ARM (adjustable rate mortgage) is a one month adjustable loan that adjusts with an index called the Twelve Month Treasury Average. Currently the index is at 5.014. The loan then has a margin which I typically see between 2.4 and 3.5%. The FIR (fully indexed rate) is calculated by adding the index and margin together. The high end of the example would be 5.014 + 3.5 which totals 8.514% interest rate. When these loans are advertised and sold, what you see and hear is 1% payments, or 50% off your payment. If you are paying only 1% on a loan with an 8.514% interest rate, negative amortization occurs. Interest grows at over eight percent, but you are paying one percent. This means that the 7.514% difference is tacked on to the principal balance of your loan, causing your loan to grow. In addition, once your loan reaches 110%-125% of the original balance (varies by lender), the loan is recast. Recasting is when the remaining principal balance of the loan must be repaid over the remaining term. If in three years your $500,000 loan grows to $550,000, you could be stuck paying principal and interest payments at 8.514% crunched into the remaining 27 years. The 1% payment would have started at $1754.03 while at recast it would jump to $4,234.90, over a 200% increase in payment.

As scary as that scenario sounds, a borrower should not have been given this loan unless they actually qualified at that higher payment level. With that being said, what if the borrower that has the above loan was stashing away, over that three years the difference in payment of $2480.87 (4234.90-1754.03=2480.87)? And, what if they used a proven financial planner that was getting them an 8% return on their investment? At the end of three years, that side account grows to $104,377. Take $50,000 and put it back into your mortgage to get it back to $500,000, add an additional $12,339 to the mortgage for principal that you would have paid down on a fixed loan, and you’ve come out ahead $42,038. Not so scary now?

There are uses for the option arm in the market place today. Consult a licensed mortgage professional if you are considering this loan. Take a hard look at the margin being offered, not just the rate at which you will make payments. Ask when the loan will recast, ask what the principal and interest payment is, and make sure you can afford the highest payment. If your goal is not to increase your assets through side accounts or investment real estate, this is most likely not a good loan for you. In addition, ask about the prepayment penalty terms, you do not have to take a prepayment penalty on this loan.

Unfortunately, too many unscrupulous loan officers do these loans at the highest margin, with the longest prepayment penalty available to earn very high commissions, while only highlighting for the borrower the low payment and pay rate and they forget to mention and disclose what negative amortization and recasting is.

For more information on real estate buying, selling, and financing, we invite you to listen to Straight Talk Real Estate every Saturday from 11am to Noon on AM830. Visit the website at www.StraightTalkRE.com for informative free reports.

Chuck Gebert is a licensed Mortgage Advisor with Troxler & Associates, Inc. located in Calabasas and can be reached at (888) 8-4-CHUCK for more information. Troxler and Associates, Inc. is licensed by the CA Dept of Real Estate Broker License #01096916.