- The Washington Times - Thursday, September 8, 2005

Q:With all the hype about interest-only mortgages, I’m wondering why negative

amortization loans aren’t in the spotlight. Would you recommend a loan with negative amortization since property values are going up so quickly?

A: You’re right about one thing: Interest-only (IO) loans have captured the media’s attention a lot more than negative amortization loans. Let me explain both.

IO loans allow the borrower’s payment to be equal to the interest charged for that month. The principal balance does not change.

IO loans have gained popularity in recent years, especially in areas such as Washington that have experienced a sharp increase in real estate values. Simply put, IO loans have enabled more folks to buy homes in the pricier areas.

Negative amortization or “neg am” loans take it a step further. The program allows the borrower to make a minimum payment based on some predetermined formula. If the minimum payment is less than the interest charged, the balance of the loan increases.

These products aren’t necessarily bad as long as they are understood and used responsibly.

Critics of IO loans charge that homeowners who pay only interest never reduce their mortgage debt. This may be true, but it isn’t always a bad thing.

Consider the following: Hal and Mary are empty nesters and have a $220,000 balance on their home that’s worth more than $800,000. They plan on retiring in five to seven years, selling their property and moving to Florida.

They currently have a 30-year fixed-rate mortgage at 6.25 percent.

Hal and Mary decide that they want to lower their monthly payment, so their mortgage broker advises them to take out an I0, seven-year adjustable rate loan at 5.75 percent. Their payment drops by more than 20 percent for two reasons.

First, the loan program allows interest-only payments.

Second, the interest rate drops by ½ percent. They’re not worried about the rate increasing after seven years because they will be selling the house and paying off the loan.

For Hal and Mary, an IO loan is perfectly suitable. There’s no risk of the interest rate jumping up because their hold period is only seven years. There’s no real urgency to build equity in the property by chipping away at the principal balance because their equity already exceeds half a million dollars.

Now let’s look at Joe and Barbara — first-time home buyers who have moved into the area and are searching for a home. Shocked by the lofty prices, they find a house that, by all reasonable tests, is out of their affordability range at $450,000. It’s no secret, however, that lenders have an insatiable appetite for loans and are always creating products to feed their hunger.

Joe and Barbara find a lender who offers them a 1.50 percent payment “option ARM.” The interest rate fluctuates monthly and is currently 5.50 percent. The payment, however, is based on an interest rate of 1.50 percent.

At 5.50 percent, the actual interest charged per month is almost $2,000 per month, but the minimum payment is only $1,500. Joe and Barbara are delighted with the program so they ratify the contract, scrape up a 5 percent down payment and close on the deal.

They understand that their principal balance increases by $500 but don’t care. Joe is in the military and will be transferred in three years, so he wants to put as little cash in the house as possible. In three years, they will sell the property at a huge profit and move on.

What’s wrong with this picture? Well, it doesn’t take a genius to realize that Joe and Barbara are speculating. House values have been skyrocketing for several years now, and may continue to do so.

But it’s perfectly reasonable to suggest that we might be in store for a temporary dip — one that could last far more than three years. Let’s take a look at the gloomy picture for Joe and Barbara if such a scenario occurs.

Joe and Barbara paid $450,000 for their house and put 5 percent down, creating a loan of $427,500. If they continue to defer $500 of interest expense a month for three years, their balance would increase by $18,000, creating a balance of $445,500 by the time they need to sell.

Let’s figure on $30,000 for real estate sales commissions, and let’s say the agent recommends that the house receive a new coat of paint and carpeting, costing $10,000 in order to sell quickly at top dollar.

Add the mortgage balance, the sales commissions and the spruce-up costs, and we have a total of $485,500. This means that Joe and Barbara must sell their house for $485,500. Anything less would mean that they have to head to the settlement table with a checkbook in hand because it’s going to cost them money to sell their house.

Now, if real estate prices continue to rise sharply, they’re not in any trouble. But if the market flattens, Joe and Barbara don’t have a lot of choices.

A negative amortization loan, like anything else, can be a good thing. It simply gives the borrower more options, but if you combine a neg am loan with a Joe-and-Barbara scenario, the ante is upped considerably.

Henry Savage is president of PMC mortgage in Alexandria. Contact him by e-mail ([email protected]).


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