Negative Amortization

What are Negative Amortization Loans?

Definition:  An increase in the Outstanding Balance of a loan resulting from the failure of periodic debt service payments to cover required interest charged on the loan.  Generally occurs under Indexed Loans for which the applicable interest rate may be changed without affecting the monthly payments.  Negative Amortization will occur if the indexed interest rate is increased.

Example:  A loan is originated at 8.0% interest with a Maturity of 30 years.  The interest rate may be adjusted each 6 months, but monthly payments remain a constant $1,600.  After 6 months, the interest rate is raised to 9.5%, which would require a monthly payment of $2,024.14 to fully amortize the loan.  At the new interest rate, $1,900 is required to pay interest.  The $300 difference between the payment and interest due is added to the principal in month 7 as "negative amortization.

Negative Amortization is a "feature" or "option" on some types of variable rate loans.  Negative Amortization is also known as "Neg-Am" or "Deferred Interest." These loans were made popular by Home Savings of America (now defunct), World Savings (merged with Wachovia Bank) and Washington  Mutual in the 1980's. Negative Amortizing mortgage products typically are advertised by the "start rate" or very low initial monthly payment instead of the actual "interest rate."  The actual "interest rate," which we know is the percentage of a sum of money charged for its use, is the finance charge on the principal.  And then there is the "start rate".  The start-rate is the cause for some of the mystery revolving around this mortgage product and can be confusing if it is not explained correctly and in great detail.

The "start-rate" is a hypothetical number (in most cases) that the lender or bank uses to determine your initial or required mininum monthly payment to keep the loan in good standing.  In some cases, the bank or lender may even offer this "start rate" as an actual initial interest rate, but that rate will last no longer than one month, thereafter reverting to the "fully indexed rate. 

The "fully indexed rate" is the actual interest rate that is being used to calculate the cost of borrowing money, for the rest of the term of the loan.  The "fully indexed rate" is calculated by adding the loan's "margin" to the current value of the "index."

The "start rate" can also be referred to as a "teaser rate, "pay rate," "intro rate," "introductory rate," or the "one month fixed rate."

Example:  1% start rate, $300,000 loan amount, 7.5% fully indexed rate, 30 year term.  The bank uses the start rate to determine your initial minimum monthly payment.  1% start rate = $964.92 per month.  If the actual interest rate was 1%, then making this payment for the full 30 years would result in the full amortization of this loan.  However, because the "fully indexed rate" is 7.5%, the actual monthly payment required to fully amortize the loan over 30 years is much higher, at $2,097.64 per month, for the very same loan.  At the fully indexed rate, $1,875.00 is required to pay interest.  If only the minimum payment is made, the $910.08 difference between the minimum payment and interest due is added to the principal in month 1 as "negative amortization."  Thus, the beginning loan balance in month 2 of this example would be $300,910.08.

This loan payment is less than the actual interest accruing on the principal, resulting in negative amortization.  Confused?  You might be. 

Why would you want a loan with a negative amortization feature like this?  For several reasons:

1.  You can invest the difference, and possibly get a better after-tax return on investment versus the fully indexed rate the mortgage offers.  Mortgage interest can be tax-deductible, thus reducing your overall cost of borrowing when factoring in tax benefits.  Consult your tax advisor to find out if you can deduct mortgage interest from your taxes.

2.  Your income fluctuates from month-to-month, as with commisioned and self-employed borrowers.  The lower minimum payment option can be used as a "crutch" to get through a tough month or to help raise cash to cover an unexpected expense.

3.  You own multiple "vacation homes," and want to maximize your interest deduction in the year taken by only making a full interest payment on the mortgage you plan on claiming the deduction on for a given tax year.  The other properties you could elect to "defer" making interest payments until you are ready to claim the mortgage expense.  Consult your tax advisor to find out if you can deduct mortgage interest from your taxes.

4.  You own an investment property, and want the option to defer mortgage interest so that you can make a lower payment while the property is vacant, while you are making repairs, or to increase monthly cash-flow.

5.  You can use this type of loan to reduce your overall housing expense, in the short-term, and thus increase your monthly household disposible income to handle paying off non-mortgage debt, such as car payments, higher-interest credit cards, higher-interest installment or signature loans, or even to help pay for college tuition and eduction expenses.  Once the non-mortgage debt is paid off, you can use the increased funds (higher disposible income) to pay off the "deferred interest" on the loan.

You also need to know about the risks associated with this type of mortgage:

1.  Your home is at risk if you do not make your payments, same as any other mortgage.

2.  The interest-rate ceiling (or maximum interest rate allowed) can be as high as 13.95%.  Variable interest rates typically change monthly on this type of loan, and will increase or decrease based on prevailing market conditions.  

3.  You may trigger a "recasting" of your loan if you defer too much interest.  Recasting, which refers to the process of adjusting a loan arrangement, would happen if your loan balance reached the maximum amount allowed by your lender.  Example:  You take out a $100,000 mortgage and the maximum loan balance allowed is $115,000.  If you make the minimum payment on this loan, once your loan balance reaches the maximum balance, the lender will require that you start paying back the principal and interest with a higher monthly payment.  In some cases, it will be just the full interest payment that is required.  In other cases, the full principal and interest payment will be required.  This can in come cases triple or even quadruple your current house payment.  If you could not afford the increased payment, you might be forced to refinance or sell your home to pay off the mortgage.

4.  You can only afford the advertised "minimum monthly payment."  Loans with the "negative amortization" feature offer really, really low monthly payments.  If you are a spender, or experience a change in your financial status, you might decide to spend the increase of monthly cash flow on consummable items, or to increase your quality of life, instead of increasing your savings.  If your budget only allows for you to make the minimum payment on this type of loan, then at some point in the near future you will find yourself receiving a letter from the lender or bank informing you of your imminent monthly payment increase.  Again, if you cannot afford your payments, you may be forced into refinancing or selling your home to pay off the mortgage.

5.  You defer interest, increase your loan balance, and then your property decreases in value.  If this happens, you might not be in a position to refinance your loan.  If that is the case, you will need to pay down your loan balance and may be forced to sell your property if you cannot make the full principal and interest payment.

6.  Your goal is to pay off your home as soon as possible.  If you make just the minimum payment, your loan balance will increase instead of decrease.  This would not be the loan product for your, unless you were investing the payment difference and planned on making a large-lump sum payment to cover not only your deferred interest, but also your principal reduction amount.

7.  Falling Prey to Mortgage companies selling this type of loan to the uneducated borrower.  Be very, very careful if you don't understand completely the terms of a mortgage that offers a "negative amortization" feature, or a payment and "rate" that is "too good to be true."  Sometimes, the only thing they want you to focus on is the "low payment" and how much better your life would be if you could lower your payment by several hundred dollars each month.  To say the least, this can be a financially dangerous loan program.   This type of loan that has negative amortization characteristics is frequently referred to as a "Pick-a-Payment" or "Equity Advantage".  These mortgage products are targeted in TV and Radio advertisements to general consumers looking for a way, to put bluntly, buy more home than they can afford, or to borrower more money than they can realistically afford to pay back.  

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