Negative Amortization loan
by
Anderson Capital Funding
Have you seen the ads recently claming that you can get a 5.0% fixed mortgage rate for 30 years? How about the ads that promises you a low fixed rate of only 1.0% on your mortgage? I even heard one on the radio the other day that claimed you could have a monthly payment as low as your cell phone bill.
Hopefully you were not suckered in buy these ads. I get so upset by mortgage companies that will say anything to get your business. Don’t get me wrong, these loans do exist, but there is a lot they are not telling you.
These ads are talking about a “Negative Amortization Loan” AKA Neg Am loan. These are the most difficult loans for the average consumer to understand. I would venture to say that many of the loan officers that sell these loans don’t even understand them. If they do, they sure don’t want you to understand them. What really frost my buns is that there is a real purpose for these loans. When the consumer understands the loan and under the right circumstances this can be a very useful loan.
What is a Neg Am Loan and how do they work
These loans are all designed with four payment options each month.
- Minimum fixed payment
- Interest only payment
- 30 year fully amortized payment
- 15 year fully amortized payment
Many come with a very low start rate of around 1.0% and last for only one to three months.
Each month you have the option of making one of the four payment options. The borrower is required to make at least the minimum payment, usually below the true rate on interest. This “payment rate” is fixed and can be from 1.0% to over 4.0% depending on the terms of the loan. Most of the ones you here about are at 1.0% and sound great when you see how low your payment will be each month. What they don’t seem to explain, is what happens to your loan balance each month, if you always make that minimum payment. Instead of paying down the loan balance, in most markets, you are negatively amortizing and so your loan balance is going up. I will go into more detail later but just keep in mind that you may be going backwards on your loan.
Your second option is to make the interest only payment. Your interest only payment is the fully indexed rate times the balance divided by 12months. This payment will be a lot less that your fully Amortized rate and I will make this more clear in later in this article.
Your last two options are to make a 30 or 15 year fully amortized loan payment.
Do you see why so many people are confused about this loan? Well it gets worse.
Let me see if I can clear it up for you with an example;
A borrower is going to take out a $400,000 loan and decides to do a Neg Am loan. All Neg Am loans have true rates of interest. This interest is computed using an index (usually the LIBOR of MTA). True rates of interest can fluctuate monthly after the initial introductory period (usually 1 or 3 months) in this example I am using the MTA as of January 2007 of 4.933%
$400,000 loan amount
- Index + Margin = True Interest Rate
- Minimum payment = 1.0%
- MTA Index 4.933% (Jan. 07)
- Margin 3.025%
- Fully Indexed 7.958% = $2,652.67 per month payment
- Pay Rate 1.0% = $1,286.56 per month minimum payment
- Negative amortization = ($1,366.11)
After only one year this borrower would owe $416,393.34 + on a $400,000 loan.
The “Recast Time Bomb”
Another feature of this loan is the “Recast” feature. Most lenders will put a 3 year pre-payment penalty on these loans because they get points from the lender to do so. That means more money in there pocket and the lender likes it because they know you will be in the loan for at least 3 years.
The Recast feature means that the loan will have a 110% to 125% clause in it. Most of the loans today recast after your loan gets to over 110% of the original loan amount. What that means is that if the loan ever goes over 110% of the $400,000 (in our example above) the lender will recast the loan and there minimum payment will go up substantially.
Example: same $400,000 loan as above
- On that loan of $400,000 you would have negative amortization of $16,193 per year
- The loan would then recast after 2.4 years when loan goes over the 110% clause
- The minimum payment would go to $3,242 from the original $1,286
That is a huge jump in monthly payments and on top of that, if the loan agent put on that 3 year pre-payment penalty you are stuck in the loan for another 6 months before you could refinance without paying a huge pre-payment penalty.
When and how should you use this loan?
Remember I said that there are times when this loan should be used. I will give you some examples of when this loan works and just remember that you should never let a loan agent stick you with a pre-payment penalty on this loan.
- Investors will use this loan when they are trying to avoid negative cash flow on a home that is in an area that the values are going up at a rate greater than the negative amortization on the loan
- Someone just out of college moving into a new job that they know their income is going to go up substantially in the next few years and they want to get a nice home now and take advantage of the lower prices today
- Self-employed consumer with a business that is seasonal. When business is slow they can make the minimum payment and make up for it when business is good.
There are other reasons but I think you get the point. As a mortgage broker I never use this loan unless it makes sense for my client and I have explained every aspect of the loan to them. If you have other questions about this loan you can find me on the web at
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