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 Questions about "deferred interest" also called "negative amortization":
"Don't get that Option ARM loan because it has NEGATIVE AMORTIZATION!" (your loan balance will go higher) 

I often hear this remark after my prospective client has asked another Mortgage Broker or Real Estate Agent (who doesn't offer the Option ARM mortgage) what they know about the program.  Usually the other Broker/Agent will say the "Pay Option ARM program has a terrible feature called negative amortization."  I've also had a few of my clients well intentioned, but uninformed accountants also tell them it's not a good idea to pay only the Minimum payment" because you will have negative amortization.

My first response is the "Minimum payment" is only an option, i.e. you are not forced to pay it; moreover, the Option ARM  has a "built in" home equity loan as you are allowed to make "minimum" monthly pmts. (less than the P&I) in order to first pay off credit card debt. You can even lower your future monthly payments on this program without ever having to refinance.  My next response would be in a question...... " Have you ever proposed to any of your clients a 2nd mtg. to pay off credit card debt?  They  will almost always say "yes", but only to "pay off debt or to do needed home improvements."  I'll then explain that a home equity loan will:

  • Have closing cost
  • Your client will receive a higher interest rate than a Option ARM fully-indexed Rate
  • Your client will usually receive a possible balloon pmt. feature
  • A home equity loan increases the mortgage balance
  • Your Client will have less monthly cash flow than in they just refinanced into an Option ARM 
 

1. "What is Deferred Interest, Anyway?"

With the all Option ARMs, choosing the OPTION of the "Minimum payment" sometimes doesn't cover all of the Interest due that month. When that happens, you "defer" the extra Interest by adding it to the outstanding balance of your mortgage.

*Deferred interest may occur if:

  • You are paying only the "MINIMUM PAYMENT" option.
  • The * 7.5% Annual payment cap goes into effect.
  • The INDEX that determines the fully-indexed Rate on your loan goes up.

However, the factors that cause deferred interest (negative amortization) are also the factors that make a loan affordable:

  • A MINIMUM PAYMENT allows payments to remain low during the critical early years of home ownership.
  • PAYMENT CAPS limit how much the monthly payment can rise each year. - (payments can also drop when the Index-falls.)
     

2. "How Will I Ever Pay Off My Loan If Deferred Interest Is Making My Balance Go Up?"

Your Option ARM mortgage is designed to pay off on time; it is guaranteed. While there are occasions when deferred interest can add to your loan balance, there are may other periods when your loan pays off at a faster than normal rate. Over time, these periods of deferred interest and faster payoff offset each other. The result: your mortgage pays off on schedule.
 

3. "Must I Have Deferred Interest On My Loan?"

No. Your loan has a Deferred Interest Payment Option that offers you a variety of choices on how to pay off your loan. These payment choices are clearly listed on the payment coupon of your monthly loan statement. You can, if you choose, pay all interest as it accrues, thereby avoiding having deferred interest added to your loan balance. You'll also always have an option to make a pmt. based upon the fully indexed rate or Index + Margin, thus avoiding negative amortization all together.
 

4. "Is It To My Advantage To Pay Deferred Interest As It Occurs?"

It all depends on your financial situation. For some homeowners, it's wise to pay all the Principal and Interest as it occurs. For many others, it makes more financial sense to pay just the Interest that is due, and others will opt to defer both their Principal and Interest, as they are looking for the lowest pmts. possible.
 

The advantages of having a "Deferred Interest/Negative Amortization" option :

Electing not to pay all the Principal and Interest will mean more cash in your pocket or extra cash-flow. Choosing this option (Minimum Pmt.) makes financial sense if it helps you:

  • A. Keep house payments affordable in case of the loss of a job.
  • B. Save money by paying debts with higher interest rates than your mortgage.

 

*Your existing loan balance may never exceed 110% (some programs have 115% up to 125%) of the original balance amount in any 5 year period.  If deferred interest (negative amortization) ever caused your balance to reach these limits, the Lender would immediately increase your Minimum payment without regard to the 7.5% payment cap. The increased Minimum payment would pay off the loan at the then current fully-indexed rate (Index + Margin) and remaining term. In that event, in the 5th, 10th, 15th, 20th, and 25th years, the Lender would take the amount of deferred interest, add it to the existing balance, and "recast" or re-amortize the loan so that it will still pay off on its original term. Moreover, some Lenders have the right to recast your amortization or term at any time if you deferred Interest to the 110%, 115% or 125% max regardless of the yearly payment cap.  

 

05/18/2000: Choosing an ARM with negative amortization ... read

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What is negative amortization? It sounds like a bad thing,
but it may be good for you

Monday, September 18, 2000

By Dian Hymer
Inman News Features

Recently a couple moved from the mid-West to the San Francisco Bay Area. They had no trouble selling their Wisconsin home, but they had difficulty qualifying to buy a home in the pricey Bay Area. So, to make qualifying easier, they used an adjustable rate mortgage (ARM)-one with a payment cap.

ARMs have an interest rate that fluctuates during the term of the loan. The specifics of how an ARM works varies with the type of ARM and the lender. But most ARMs have limits on how high the interest rate can go at each adjustment (called a periodic cap), and over the life of the loan (called a lifetime cap). Some ARMs have payment caps that set limits on how high the monthly payment can go when the interest rate rises.

ARMs that have payment caps usually limit the amount the monthly payment can increase at each interest rate adjustment to 7.5 percent of the previous payment amount. If the amount of interest owed exceeds the capped payment amount, and the borrower chooses to pay only the minimum payment due, negative amortization can occur.

Even though your payment is capped, you are not relieved of the responsibility for paying the additional interest due. The payment of this interest is deferred and is added to the remaining loan balance. When this happens, your loan balance increases with each mortgage payment. This is called negative amortization.

Some borrowers are afraid of ARMs that have the possibility of negative amortization. Usually they don't understand how these loans work. Although there are risks involved, ARMs with payment caps have benefits for some borrowers.

For instance, ARMs that are tied to the Eleventh District Cost of Funds Index (COFI) are noted for their low volatility. However, most COFI ARMs have payment caps.

FIRST-TIME TIP: Most ARMs with payment caps give you three payment options. You can make a regular, or fully amortized, payment. Fully amortized payments pay a loan off in full during the loan term (usually 30 years). Each monthly payment pays the entire amount of the interest owed plus a portion of the principal loan amount. Another option, which costs less than an amortizing payment, is to make an interest-only payment. Or you can make the capped payment, which is the minimum amount due. If you select either of the first two payment options above, you'll avoid negative amortization.

ARMs with payment caps are often the loan of choice for borrowers who work on commission. Real estate sales people usually work on commission and given the seasonal nature of the real estate business, their monthly income can fluctuate widely. An ARM with a payment cap gives the borrower the option of paying the minimum payment due during lean months. When income increases, the borrower can make larger monthly payments and pay off any accrued interest.

An ARM with a payment cap might be attractive to a salaried borrower who is experiencing a temporary decline in income. This loan is also popular with homebuyers who buy a new home before selling their current home. In either case, the minimum payment due option can come in handy.

THE CLOSING: There is less risk with negative amortization when home prices are rising. When property values are falling, however, these loans can be risky if you have to sell in a down market. If you buy with 5 or 10 percent down, and then interest rates rise and property values drop, you could find that the remaining amount due on your mortgage is more than the sale price of your home.

Dian Hymer is author of "Starting Out, The Complete Home Buyer's Guide," Chronicle Books.

 

 

 
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