Another look at negative amortizationDavid M. Greenpayment-option ARM, pick-a-payment loan, adjustable-rate mortgage With real estate prices marching ever higher, first-time homebuyers are finding it increasingly difficult to find an affordable mortgage solution. Whoever dreamed they would hear the words, "$500,000 starter home"? Mortgage lenders have responded with a variety of products not seen since the inflated rates of the late 70s and early 80s. These are all designed to lower the borrower's payments, particularly in the early years of the mortgage. The idea is to get a buyer into a home they wouldn't normally be able to afford with a traditional 30-year mortgage. One of the fastest growing of these "new" mortgages is a negative amortization mortgage (NegAm), typically called a "payment-option ARM" (adjustable-rate mortgage) or "pick a payment" loan. Although the words "negative amortization" can send shivers down the spine of the mortgage community, as this article will discuss, there has been a drastic change in how borrowers perceive mortgages. They want lower payments, of course, but just as important is actual control over the payments themselves. A quick refresher course For those readers unfamiliar with NegAm, let me explain. Typically, monthly mortgage payments are comprised of interest, which is a charge for the use of the mortgage money you've borrowed, plus a sum that goes to principal to reduce your actual debt. At the outset, most of the payment is interest. Over time, the trend reverses and most of the payment is principal. Eventually, the mortgage is paid off. A NegAm loan allows buyers to pay less than the full amount of interest necessary to cover the interest accruing on the principal balance. The difference between a full interest payment and the amount actually paid each month is then added to the principal. There is a limit to the amount of NegAm you can accumulate, typically 110 or 125 percent of the original principal balance. Not your father's NegAm loan Mortgage lenders today are faced with a difficult challenge: combining exploding housing values with a more sophisticated and demanding borrowing public. The solution offered more and more is built around a NegAm payment, and it is called a "payment-option ARM" or "pick a payment" loan. These products provide more opportunities for financially savvy borrowers who seek more customized, and ultimately less costly, home finance choices. These loans are typically offered by savings and loan institutions, which keep them in their portfolios, such as World Savings Bank (a subsidiary of Golden West Financial), Countrywide Home Loans, Washington Mutual and IndyMac Bancorp. They are appealing to homeowners with variable income, such as the self-employed, those in construction work and those who rely on bonuses for much of their income. The loans are popular partially because the prices of homes and the cost of living in many areas far outstrips most people's incomes. Moreover, these programs offer great flexibility when qualifying for a mortgage. Many lenders allow homebuyers with good credit to apply without documenting their income, assets or source of down payment. This is helpful for self-employed borrowers or those who have jobs where it is difficult to document their income. These ARMs are offered with a very low initial rate. Some lenders will allow a borrower to qualify for a larger loan due to this initially lower rate. This loan offers borrowers much greater control of their finances, as compared with a fixed-rate mortgage, when they start making payments. The linchpin is that the borrower gets to manage their own money with up to four payment options each month. These are the typical choices of the programs offered: 1. Minimum payment/NegAm payment: The smallest payment lets the borrower keep the most cash now. Generally, this payment changes annually and is calculated using the initial interest rate for the first 12 months. After that, the minimum payment is usually recalculated based on the outstanding principal balance, remaining loan term and prevailing interest rate. A payment cap, usually 7.5 percent, limits how much this payment can increase or decrease each year. If the borrower makes only the "minimum payment" option, their loan balance will increase (NegAm) for the first few years. This option is allowed by the lender without hurting any credit rating or charging any type of late fees. Hence, the monthly minimum payment is not sufficient to pay the full amount of the interest due; the lender adds this accrued but unpaid interest to the unpaid principal balance of the loan. 2. Interest-only payment: This keeps payments manageable while paying all of the interest. At those times when the minimum payment is not enough to pay the monthly interest due, you can avoid NegAm with this option. The borrower pays the minimum monthly payment and all additional interest accrued during the month. This option does not result in principal reduction. 3. Fully amortized payment: This reduces the borrower's principal and pays off their loan on schedule. It is calculated each month based on the prior month's interest rate, loan balance and remaining loan term. It operates just like a traditional fixed-rate payment; however, the borrower is not obligated to make this payment from month to month. 4. Fifteen-year payment: This builds equity faster than the fully amortized payment because the borrower pays off their loan quicker and saves on interest. It is calculated to amortize your loan based on a 15-year term from the first payment due date. Since the majority of all NegAm loans are never sold on the secondary market, the borrower is given these choices on a monthly basis. If the borrower elects to pay just the minimum payment, their loan will still be paid off in 30 years (or 25 years with the bi-weekly program some lenders offer) because the lender will take that minimum payment and increase it by a factor of 7.5 percent for year two and so on, until the minimum payment catches up to the full principal and interest payment. The sales pitch Most, if not all of the lenders who offer this product concentrate their marketing efforts on the first payment choice, the minimum or NegAm payment. This is not surprising since the borrowers payment can be reduced by as much as 40-50 percent! On a $750,000 mortgage, as an example, a 30-year, fixed-rate loan at six percent would have a monthly principal and interest payment of $4,496. With the payment-option ARM, a one percent start rate would generate a payment of $2,400! (The interest-only payment would be $2,465). Many lenders contend that you could actually pay your NegAm mortgage off faster by making only the "minimum payments" by saving or investing just the first five years difference in payments (instead of making full principal and interest payments) into a safe mutual fund or indexed fund-balanced portfolio. If the borrower is disciplined, does not touch this savings and re-invests the dividends, this money would grow fast enough (if you could earn at least eight-10 percent annually) to allow you to pay your mortgage off in 20 to 25 years (by adding a one-time extra payment), and still have plenty of money left over. Thus, a large advantage of NegAm loans is that the borrower can control cash flow (a relatively stable payment), take advantage of low interest rates relative to the market at any given time, and pay back the money borrowed today at a depreciated value years from now (because of inflation). Moreover, they add a level of sophistication that cannot be achieved with a vanilla, fixed-rate loan. For example, they can be used for tax planning. The borrower can defer interest payments and, at the end of the year, analyze their tax situation. If it serves their tax interests, they can make a lump sum payment toward any interest that has been deferred and deduct it for tax purposes. Other benefits espoused by lenders in electing not to pay the entire principal and interest include the following: •Keep house payments affordable in case of job loss; •Save money by paying debts with higher interest rates than your mortgage, i.e. credit cards; •Make home improvements that increase the value of your property; •Build a college fund for your children; •Like a home equity line of credit/second mortgage to improve your house, thus increasing your market value; and •Use to purchase a rental propertyin the case of loss of rental income, use the minimum payment option until fully tenanted. Cons A NegAm loan will always have a strike against it because of the risks of having the loan principal increase rather than decrease and, in extreme cases, even exceed the value of the borrower's home. In a contracting market, it is possible to owe more than the mortgage balance, thus incurring the dreaded "negative equity" scenario. Also, ARMs with payment caps are usually re-amortized or recast at some point, so that the remaining balance can be fully paid off during the term of the loan. This would most likely result in a higher monthly payment. It is worth noting that since the beginning of these NegAm products, the "recast provision" has never come into force because the indices used move very slowly. Many borrowers will not qualify for these loans, as lenders enforce strict credit guidelines and conservative appraisal valuations. Finally, there are some higher closing costs associated with a NegAm loan. In New York state, mortgage tax is based on the NegAm amount. Also, a lender's title insurance policy is based on the NegAm amount. Conclusion NegAm products provide more opportunities for financially savvy borrowers who seek more customized and, ultimately, less costly home finance choices. The costs associated with home ownership generate demand for these types of mortgage products. I firmly believe that these loans serve a very useful purpose to a growing niche market. David M. Green is an attorney with Carle Place, N.Y.-based Consumer Settlement LLC. He may be reached at (516) 213-2757 or e-mail [email protected].