Negative Amortization

Negative Amortization

Negative amortization arises when the mortgage payment is smaller than the interest due and that causes your loan balance to increase rather than decrease. Your mortgage payment has two parts: an interest payment covering the interest due for that month, and a principal payment. The principal payment reduces the loan balance and is called "amortization." For example, the monthly mortgage payment on a 30-year fixed-rate loan of $100,000 at 6% is about $600. In the first month, the interest due the lender is $500, leaving $100 for amortization. The balance at the end of month one would be $99,900. The $600 payment is a "fully amortizing" payment. If you continue to pay that amount every month during the period remaining to term and the interest rate does not change, the loan will be paid off at term. A $550 payment would be partially amortizing, leaving a balance at the end of the loan’s term. A $500 payment would just cover the interest – there would be no amortization. If your payment is only $400, it would fall short of the interest due by $100 and the loan balance would rise to $100,100. In effect, the lender makes an additional loan of $100, which is added to the amount you already owe. This rise in the loan balance is called negative amortization. Negative amortization can only arise on ARMs with one or more of the following features: •

The initial payment does not cover the interest due, as in the example. The purpose of such a feature is to increase affordability.

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The interest rate adjusts more frequently than the monthly payment. The purpose of this feature is to avoid frequent changes in your monthly payment.

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Changes in the monthly payment are capped, usually at 7.5%. The purpose is to avoid large changes in the payment.

But these borrower-friendly features have a downside. If interest rates rise persistently, the equity in your house will decline rather than rise unless the negative amortization is offset by house appreciation. In addition, negative amortization must be repaid, which means that your payment is going to rise in the future. The larger the negative amortization, the greater will be the increase in the future payments that will be required to amortize the loan in full. Negative amortization is limited, but the implication that the limit protects you is misleading, at best. The limit is designed to protect the lender, not you. If you ever reach the limit, the lender immediately raises the mortgage payment to the fully amortizing level, regardless of how large an increase that might be. A negative amortization cap overrides a payment adjustment cap. The negative amortization cap would be reached only if interest rates increase persistently over a long period. In Is a 3.95% ARM a Good Deal?, I examine what would happen to the payment and to the loan balance on a negative amortization ARM if interest rates rose by 1% a year for 5 consecutive years. This ARM had monthly rate adjustments, annual payment adjustments capped at 7.5%, and an initial payment below the interest payment.

The payment on this ARM would rise by 7.5% in months 13, 25, 37, 49, 61 and 73. But in month 82, two months prior to the next scheduled payment adjustment, the loan balance would hit 125% of the original balance. At that point, the payment would jump by 77%. I conclude that while this was an unlikely event, it was not impossible. ARMs that allow negative amortization can increase home affordability, and may also offer lower interest costs than other mortgages, provided that interest rates don’t rise persistently. As with most everything else in finance, the benefits come packaged with risk.

Negative Amortization and Related Concepts Ordinarily, the mortgage payment you make to the lender has two parts: interest due the lender for the month, and amortization of principal. Amortization means reduction in the loan balance -the amount you still owe the lender. For example, the monthly mortgage payment on a level payment 30-year fixed-rate loan of $100,000 at 6% is $600. In the first month, the interest due the lender is $500, which leaves $100 for amortization. The balance at the end of month one would be $99,900. Because a payment of $600 a month maintained over 30 years would just pay off the balance, assuming no change in the interest rate, it is said to be the fully amortizing payment. A payment less than $600 would leave a balance at the end of 30 years. A payment greater than $600 would pay off the loan before 30 years. Suppose you made a payment of $550, for example. Then only $50 would be available to reduce the balance. Amortization would still occur, but it would be smaller and not sufficient to reduce the balance to zero over the term of the loan. $550 is a partially amortizing payment. Next, suppose you pay only $500. Since this just covers the interest, there would be no amortization, and the balance would remain at $100,000. The monthly payment is interest-only. Back in the 1920s, interest-only loans usually ran for the term of the loan, so that the borrower owed as much at the end of the term as at the beginning. Unless the house was sold during the period, the borrower would have to refinance the loan at term. Today, some loans are interest-only for a period of years at the beginning, but then the payment is raised to the fully-amortizing level. For example, if the loan referred to above was interest-only for the first 5 years, at the end of that period the payment would be raised to $644. This is the fully-amortizing payment when there are only 25 years left to go. Finally, suppose that for some reason, your mortgage payment in the first month was only $400. Then there would be a shortfall in the interest payment, which would be added to the loan balance. At the end of month one you would owe $100,100. In effect, the lender has made an additional loan of $100, which is added to the amount you already owe. When the payment does not cover the interest, the resulting increase in the loan balance is negative amortization. Purposes of Negative Amortization Historically, the major purpose of negative amortization has been to reduce the mortgage payment at the beginning of the loan contract. It has been used for this purpose on both fixed-rate mortgages (FRMs) and adjustable rate mortgages (ARMs). A second purpose, applicable only to ARMs, has been to reduce the potential for payment shock -- a very large increase in the mortgage payment associated with an increase in the ARM interest rate.

The downside of negative amortization is that the payment must be increased later in the life of the mortgage. The larger the amount of negative amortization and the longer the period over which it occurs, the larger the increase in the payment that will be needed later on to fully amortize the loan. Negative Amortization on Fixed-Rate Loans On fixed-rate loans, negative amortization is a tool for reducing the mortgage payment in the early years of a loan, at the cost of raising the payment later on. Instruments that incorporate this feature are called graduated payment mortgages or GPMs. There are many possible GPMs that differ in terms of the size of the payment increase and the number of years over which increases occur. The following is a small sampling of 6% 30-year GPMs compared to the standard levelpayment mortgage described above, and to FRMs that are interest-only for varying periods.

GPMs, Interest-Only FRMs, and Standard FRMs, at 6% for 30 Years Type of Loan

Initial Payment

Highest Payment

Month Highest Payment Reached

Highest Balance

Month Highest Balance Reached

Standard Level Payment

$600

$600

1

$100,000

0

7.5% for 5 Years

$445

$639

61

$100,989

24

5% for 10 Years

$425

$692

121

$102,393

48

7.5% for 10 Years

$356

$733

121

$106,553

72

For 10 Years

$500

$716

121

$100,000

1-120

For 15 Years

$500

$844

181

$100,000

1-180

For 20 Years

$500

$1110

241

$100,000

1-240

Graduated Payment:

Interest Only:

The first GPM calls for annual increases in the mortgage payment of 7.5% for 5 years. The initial payment is $445 as compared to $600 on the standard mortgage, but the GPM payment rises to $639 in the sixth year where it remains for the balance of the term. Negative amortization is modest, the balance rising to $100,989 in month 24 before positive amortization begins. The

other GPMs have even lower initial payments but the ultimate payments are higher and negative amortization is greater. In general, the lower the initial payment on a GPM and the smaller the payment increases, the larger the negative amortization and the final payment. However, the final payment can be higher on an interest-only FRM than on a GPM, depending on how long the interest-only period is. GPMs make sense for borrowers who can confidently predict that their incomes will rise over time to at least keep pace with the rising payment. A drawback is that if they sell their house after only a few years, they will owe the lender more than when they began. A more serious drawback is that some borrowers with questionable prospects for the future nevertheless elect GPMs because it is the only way they can qualify for the loans they want. Historically, default rates on GPMs in the US have been higher than on standard level-payment loans, and lenders have become reluctant to make them as a result. In the relatively low-interest rate environment of recent years, GPMs are less needed to get the payments down to affordable levels, and they have virtually died out. Interest-only FRMs are around but they are used mainly for high net worth individuals with variable incomes who expect to prepay much of the loan balance before the end of the interestonly period. Negative Amortization and Payment Shock on Graduated Payment Adjustable Rate Mortgages In the high-interest rate environment of the early 80s, negative amortization on some adjustable rate mortgages (ARMs) served the same purpose as on GPMs – allowing reduced payments in the early years of the loan. Payments in the early years of these "GPARMs" were deliberately set lower than the interest due the lender, resulting in negative amortization. As with GPMs, the amount of this negative amortization was known in advance. If interest rates on GPARMs rose from their initial levels, however, it could result in additional negative amortization that was not known in advance. This in turn could result in payment shock. These instruments experienced default rates even higher than those on GPMs, and they soon stopped being offered in the marketplace. ARMs in the Late 90s Without Negative Amortization Most ARMs today do not have the potential for negative amortization. Whenever the interest rate is changed, the mortgage payment is adjusted immediately so that it will continue to amortize the loan fully over the portion of the original term that remains. On such ARMs, the mortgage payment is always "fully amortizing". Payment shock on ARMs that always have fully amortizing payments is avoided by capping the size of any interest rate increase. On ARMs that adjust the rate every 6 months, the cap is usually 1%, and on ARMs that adjust the rate every year the cap is usually 2%. However, on ARMs where the initial rate holds for 5, 7 or 10 years and then adjusts annually, the cap at the first rate adjustment is usually 5%, dropping to 2% on subsequent (annual) adjustments. The affordability of ARMs today is enhanced not by a graduation feature but by relatively low initial rates. In general, the shorter the period for which the initial rate holds, the lower the initial rate. ARMs in the Late 90s With Negative Amortization

The most important remaining ARM with the potential for negative amortization is the monthly adjustable -- the interest rate is adjusted every month and there is no interest rate adjustment cap. If the mortgage payments on such loans were always fully amortizing, borrowers would be vulnerable to extreme payment shock. For example, a monthly adjustable I looked at on Feb. 27, 1998 had an initial interest rate of 7.75% and a maximum rate of 12%. If markets rates exploded the month after this loan was closed, the rate would rise to 12% and the new fully amortizing payment would be 71% higher. To avoid this possibility, these loans adjust the payment only once a year subject to a payment adjustment cap of 7.5%. In the event of an interest rate explosion, the rate would go to 12%, but instead of a one-time jump in payment of 71%, the adjustment would be stretched out to annual changes of 7.5% over 6 years. But the consequence of stretching out the payment adjustment is negative amortization. For 5 years the payment would fail to cover the interest and the balance would rise to 109% of its original value before it started to come down. All other things equal, caps on interest rate adjustments are much better for the borrower than caps on payment adjustments that can result in negative amortization. The problem is that other things are seldom equal. The monthly adjustable described above adds a smaller markup ("margin") to the rate index than ARMs with rate adjustment caps, and is tied to an interest rate index that has a lower value. The bottom line is that it doesn't make sense to assess ARMs in terms of whether or not they permit negative amortization. What matters in the decision process is how the ARMs would perform in different future rate environments. On Feb. 27, 1998 when I looked at this, a monthly adjustable would perform better in a stable or declining rate environment, but worse in a rising rate environment, than other ARMs that have rate adjustment caps. However, the advantage of the monthly adjustable in a stable rate environment was small while the disadvantage in a rising rate environment was uncomfortably large -- for me. I would avoid the monthly adjustable, but someone else might feel differently. When to Consider a Negative Amortization Loan Negative amortization loans can be useful if you are primarily concerned with cash flow instead of building equity. If you only pay the payment rate, the overall monthly mortgage payment might be much lower than a typical 30-year, "no neg" amortization loan. Given this, negative amortization loans may be a temporary solution if income is reduced for a period of time, or if the hold period is short term to minimize cash outflow. Nevertheless, one of the main reasons for purchasing a home is to build equity and generate greater wealth. If you are primarily concerned with cash flow, a better strategy may be to simply rent rather than own. Negative Amortization: Risky Financing Don't do it! Negative amortization. Sounds like financial gobbletygook, but simply, it's a program offered by some lenders to tempt prospective buyers into buying more house than they might comfortably afford. When you've found the perfect house, but your finances don't quite match up for a perfect fit, you'll be confronted with a selection of different loan options from 40-year mortgages to ARMs. With so much complexity, it's not surprising that negative amortization can creep into the mix and take the innocent, the unsuspecting, and the uneducated home buyer unawares.

So what is it? Negative amortization is exactly what it says. When you take out a home loan, the payments and interest are amortized over a specific term. Conventional or fixed loans are set at a constant rate for the duration of the loan. In the beginning you pay a higher percentage in interest while only a small amount goes toward the principal. Over time, as the principal is paid down, the interest amount is reduced and the principal payment increases until the loan is finally paid off. The payment always stays the same. Other options include adjustable rate mortages (ARMs), mortgages with balloon payments, and interest only loans, for example. With negative amortization, instead of paying down the principal incrementally every month, you are instead adding to it because the payment itself is not enough to cover the interest let alone any principal. The difference is tacked on to the principal amount. Typically, when the loan hits a particular threshold between 110 and 125% of the original principle, the loan is converted to a conventional loan at a much higher interest rate. Instead of reducing the amount you owe on the principal it continues to grow, which is totally backwards from your probable goal of eventual ownership. How does this happen? With the housing market red hot in many areas now, competition is steep and home prices are climbing. This has fueled a feeding frenzy among buyers and the best market in decades for sellers. When you need to make instant decisions about purchasing, it's easy to see how a folks could get themselves in over their heads pretty quickly. The fact is there is no more emotional decision than buying a home. It's the biggest investment most of us ever make and it embodies all of our hopes and dreams regardless of its price or appointments. As a result, many home buyers, especially the first time or young buyer, look only at the monthly payments to decide if they can afford a house. With a little "creative" financing, developers, real estate agents, and lenders combine to make your dreams a reality, but not necessarily with your best long term financial interests in mind. Are negative amortizing loans ever okay? If you are in a growth region where homes have been undervalued and now seem to be catching up with the market, you might be able to purchase a home for $300,000 and then pay on a negative amortizing loan short term, tacking a modest $300 on to the principal each month. If you are able to make a few cosmetic improvements, then resell the home after a year for $400,000, then subtracting the additional principal of $3600 and cost of improvements, real estate fees and so on, you might walk away with a modest profit. The negative amortizing loan would allow you to maintain your cash flow and over a short period would be offset by the home's appreciation in the current market. However, it could easily be a losing proposition if the market or your personal circumstances change. In other words, you need to be aware of and carefully weigh the risks. Another possibility would be the case of a young professional who wants to purchase a particular type of home, but is not currently making the income to support the home desired. In a year or two they could become established in their careers and could see a substantial increase in income. Combined with a rapidly appreciating housing market, it would make some sense for someone like this to take the risk, especially if their financial prospects were particularly bright.

Negative amortization is also available as part of a few programs offered by some lenders to certain borrowers who are highly qualified that make it possible to pay less than the interest one month, interest only another, or interest and principal still other months. Such borrowing, though possible, is not the norm, because this type of borrower typically has significant assets already. The big downside Negative amortization or other "creative financing" can make it possible for you to move into the home of your dreams, but without carefully assessing the risks, those dreams could come crashing down around you. In an overheated market, the best advice is to be cautious, get prequalified by your lender in advance, and lower your sights to include homes that you can afford if circumstances change such as divorce, job loss, or extended illness.

Advantages and Disadvantages Negative amortization means that your loan balance is increasing instead of decreasing. With a negative amortization loan, when your monthly payment on an ARM (adjustable-rate mortgage) isn't enough to cover the interest expense and principal payment, the shortage is added to your loan balance. This situation arises when the adjustable-rate mortgage has a payment cap but the interest rate on the mortgage has increased. What's good about negative amortization is that your payment doesn't have to increase just because the interest rate on your ARM went up. The lender can also price the loan more aggressively because a payment cap doesn't mean that the lender can't pass along an interest rate increase. What's bad about negative amortization is that the payment will eventually reset to a level to allow the loan to amortize over its remaining life. The increase in the monthly payment needed to repay the larger loan over a shorter time span can be substantial. If rates have increased substantially, then refinancing may not be a viable option. Real estate prices may not continue to increase, especially if interest rates start trending higher. Being upside down in a mortgage loan because of negative amortization isn't pretty if you need to sell your house. I'd rather see homeowners in a 5/1 ARM or a 7/1 ARM than in a short-term ARM with a payment cap that's subject to negative amortization. Typical Circumstances All NegAM home loans eventually require full repayment of principal and interest according to the original term of the mortgage and note signed by the borrower. Most loans only allow NegAM to happen for no more than 5 years, and have terms to "Recast" (see below) the payment to a fully amortizing schedule if the borrower allows the principal balance to rise to a pre-specified amount. This loan is written often in high cost areas, because the monthly mortgage payments will be lower than any other type of financing instrument. Negative amortization loans can be high risk loans for inexperienced investors. These loans tend to be safer in a falling rate market and riskier in a rising rate market.

Adjustable Rate Feature NegAM loans today are mostly straight Adjustable Rate Mortgages (ARMs), meaning that they are fixed for a certain period and adjust every time that period has elapsed; e.g., One month fixed, adjusting every month. The NegAm loan, like all Adjustable Rate Mortgages, is tied to a specific financial index which is used to determine the interest rate based on the current index and the margin (the markup the lender charges). Most NegAm loans today are tied to the Monthly Treasury Average, in keeping with the monthly adjustments of this loan. There are also Hybrid ARM loans in which there is a period of fixed payments for months or years, followed by an increased change cycle, such as six months fixed, then monthly adjustable. The Graduated Payment Mortgage is a "fixed rate" NegAm loan, but since the payment increases over time, it has aspects of the ARM loan until amortizing payments are required. NegAm - Mortgage Terminology •

Cap - percentage rate of change in the NegAm payment. Each year, the minimum payment due rises. Most minimum payments today rise at 7.5%. Considering that raising a rate 1% on a mortgage at 5% is a 20% increase, the NegAm can grow quickly in a rising market. Typically after the 5th year, the loan is recast to an adjustable loan due in 25 years.

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Life Cap - the maximum interest rate allowed after recast according to the terms of the note. Generally most NegAm loans have a life cap of 9.95%.

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Payment Options - There are typically 4 payment options: o Minimum Payment o Interest Only Payment o 30 Year Payment o 15 Year Payment

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Period - how often the NegAm payment changes. Typically, the minimum payment rises once every twelve months in these types of loans.

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Recast - premature stop of NegAm. Should your negative balance reach a predetermined amount (typically 115% of the original balance, or 110% in New York)) your loan will be "recast" with one of two payment options: the fully amortized principal and interest payment, or if the maximum balance has been reached before the fifth year, an interest only payment until the loan has matured to the recast date. (typically 5 years)

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Stop - end of NegAm payment schedule.