Negative amortization
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In finance, negative amortization, also known as NegAm, occurs whenever the loan payment for any period is less than the interest charged over that period so that the outstanding balance of the loan increases. As an amortization method the shorted amount (difference between interest and repayment) is then added to the total amount owed to the lender. Such a practice would have to be agreed upon before shorting the payment so as to avoid default on payment. Also known as deferred interest or Graduated Payment Mortgage (GPM). This method is generally used in an introductory period before loan payments exceed interest and the loan becomes self-amortizing.
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[edit] Defining characteristics
Negative amortization only occurs in loans in which the periodic payment does not cover the amount of interest due for that loan period. The unpaid accrued interest is then capitalized monthly into the outstanding principal balance. The result of this is that the loan balance (or principal) increases by the amount of the unpaid interest on a monthly basis. The purpose of such a feature is most often for advanced cash management and/or more simply payment flexibility, but not to increase overall affordability.
Neg-Ams also have what is called a recast period and recast principal balance cap based on Federal and State legislation. The recast period is usually 60 months (5 years). The recast principal balance cap (also known as the "neg am limit") is usually up to a 25% increase of the amortized loan balance over the original loan amount. States and lenders can offer products with lesser recast periods and principal balance caps; but cannot issue loans that exceed their state and federal legislated requirements under penalty of law.
A newer loan option has been introduced which allows for a 40-year loan term. This makes the minimum payment even lower than a comparable 30-year term.
[edit] 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.
Start rates on negative amortization or minimum payment option loans can be as low as 1%. This is the payment rate, not the actual interest rate. The payment rate is used to calculate the minimum payment. Other minimum payment options include 1.95% or more.
[edit] 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.
The most notable differences between the Traditional Payment Option Arm and the Hybrid Payment Option Arm are in the start rate also known as the "minimum payment" rate. On a Traditional Payment Option Arm, the minimum payment is based on a principal and interest calculation of 1% - 2.5% on average.
The start rate on a Hybrid Payment Option Arm is higher, yet still extremely competitive payment wise.
On a Hybrid Payment Option Arm, the minimum payment is derived using the "interest only" calculation of the start rate. The start rate on the Hybrid Payment Option arm typically is calculated by taking the Fully Indexed Rate (Actual Note Rate), then subtracting 3%, which will give you the start rate.
Example: 7.5% fully indexed rate - 3% = 4.5% (4.5% would be the start rate on a Hybrid Pay Option Arm)
This guideline can vary among lenders.
Aliases the Payment Option Arm loans are known by:
- Negative Amortizing Loan (Neg Am)
- Pick - A - Pay
- Deferred Interest Option Loan (This is the way this loan was introduced to the mortgage industry when first created)
[edit] 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. This is for a 30 year loan term. Newer payment option loans often offer a 40 year term with a higher underlying interest rate.
- Life Cap - the maximum interest rate allowed after recast according to the terms of the note. Generally most NegAm loans in the last 5 years have a life cap of 9.95%. Today many of these loans are capped at 12% or above.
- Payment Options - There are typically 4 payment options:
- Minimum Payment
- Interest Only Payment
- 30 Year Payment
- 15 Year Payment
- Period - how often the NegAm payment changes. Typically, the minimum payment rises once every twelve months in these types of loans. Usually the rate of rise is 7.5%
- Recast - premature stop of NegAm. Should your negative balance reach a predetermined amount (up to 125% of the original balance per Federal or State regulations) 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)
- Stop - end of NegAm payment schedule.
[edit] Types of Negative Amortization loans
In a Reverse mortgage borrowers do not need to make payments on their loan until it is due. A reverse mortgage is due only when the borrower no longer resides in his or her principal residence.[1]
[edit] Criticisms of Negative Amortization loans
Negative Amortization loans, being relatively popular only in the last decade, have attracted a variety of criticisms:
- Unlike most other adjustable-rate loans, many negative amortization loans have been advertised with either teaser or artificially introductory interest rates or with the minimum loan payment expressed as a percentage of the loan amount. For example, a negative amortization loan is often advertised as featuring "1% interest", or by prominently displaying a 1% number without explaining the real interest rate. This practice has been done by large corporate lenders. This practice has been considered deceptive for two different reasons: most mortgages do not feature teaser rates, so consumers do not look out for them; and, many consumers aren't aware of the negative amortization side effect of only paying 1% of the loan amount per year. In addition, most negative amortization loans contain a clause saying that the payment may not increase more than 7.5% each year, except if the 5-year period is over or if the balance has grown by 15%. Critics say this clause is only there to deceive borrowers into thinking the payment could only jump a small amount, whereas in fact the other two conditions are more likely to occur.
- Negative amortization loans as a class have the highest potential for what is known as payment shock. Payment shock is when the required monthly payment jumps from one month to the next, potentially becoming unaffordable. To compare various mortgages' payment shock potential (note that the items here do not include escrow payments for insurance and taxes, which can cause changes in the payment amount):
- 30-year (or 15-year) fixed-rate fully amortized mortgages: no possible payment jump.
- 5-year adjustable-rate fully amortized mortgage: No payment jump for 5 years, then a possible payment decrease or increase based on the new interest rate.
- 5-year adjustable-interest-only mortgage: no payment jump for 5 years, then a possible payment decrease or increase based on the new interest rate, combined with an increased payment due to the requirement to pay principal over a 25 year time frame.
- Negative amortization mortgage: no payment jump either until 5 years OR the balance grows 15% higher than the original amount. The payment increases, by requiring a full interest plus principal payment. The payment could further increase due to interest rate changes. However, all things being equal, the fully amortized payment is almost triple the negative amortized payment.
In a very hot real estate market the price of a property purchased with a negative amortization mortgage may increase by more than the principal of the mortgage increases during the "negam" period. Therefore, if the property owner has a problem paying the newly amortizing payment, he/she could sell the property and maybe, even make a profit.
However, if the property's value does not increase, the owner will now owe more on the property than its worth, known colloquially in the mortgage industry as "being underwater." In this situation, if the property owner cannot make the new monthly payment, he/she may be faced with foreclosure.
It is wise to be aware of how the negative amortization mortgage's payment will change after the new amortizing payment kicks in and to be familiar with the mortgage's amortization table.
[edit] Difference Between Negative Amortization and a Reverse Mortgage
A Negative Amortization Mortgage should not be confused with a Reverse Mortgage. A Negative Amortization Mortgage is a mortgage where the principal increases throughout the early stage of the mortgage. This early stage is known as the negative amortization or negam period. During this time period the borrower is, in effect, making partial payments toward his mortgage. The remainder of his payment, which he is not paying, is added on to the amount owed on the mortgage. Naturally, when this period ends, he must start to pay this additional amount off, along with his original principal.[2]
A Reverse Mortgage happens when a homeowner, usually a retired person, sells some or all of his equity in his home and retains the right to live there. No payments are due until the homeowner moves out of the house. However the interest charged on the loan is applied back to the principal since no interest payments are made during the life of the loan.
