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Posted 08/08/2005

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Negatively Amortizing Loans Are Only Evil If You ALLOW Them Be Evil

Negatively amortizing mortgages are also known as NegAm loans and never force the borrower to add to his loan balance.  Each month, the mortgage statement comes with choices and only one choice creates a larger loan balance than before. Negatively amortizing home loans get a lot of bad press.  Some of it is deserved; most of it is not.

If you've never heard of NegAm loans, maybe you know them by their more popular, "brand" names:

  • Option ARM
  • Pick-a-Payment ARM
  • Deferred Interest Option Loan

The basic concept of a NegAm loan is that the homeowner can choose what his monthly payment will be from among several choices.  One of those choices is a "minimum required" payment that is less than the true amount owed. 

The difference between the two payments is added to the loan's principal balance.

In math, the choice to NegAm looks like this:

(New Loan Balance) = (Current Loan Balance) + ((True Monthly Mortgage Payment)-(Minimum Mortgage Payment Required))

In the hands of the wrong homeowner, NegAm loans can be is very dangerous.  Imagine borrowing $400,000 for your home and then owing $440,000 when you sell it. If you planned for that additional debt load and managed your mortgage with purpose each month, no problem!  Unfortunately, too few people actually plan or manage their mortgage.

  Many of these people in the latter group were enticed by the "minimum payment rate" and treated the NegAm products as an affordability product.

And that's the worst possible use of a mortgage allowing deferred interest.  Deferring interest is a case of pay the lender now, or pay the lender later.  There is no "affordability" in that game -- just delaying the inevitable.

So, when the press pans NegAm loans like Washington Mutual's Option ARM, it neglects the fact that negative amortization is a choice!  That choice is the reason why these negatively amortizing loans have names like Option ARM and Pick-a-Payment -- the lender is not telling the borrower how to pay back the mortgage.

Remember: there are two groups of borrowers that use NegAm loans for home financing.  One group has a mortgage plan, the other group has a spending plan.  And we've already discussing the latter group.

For members of the former, NegAm loans can be the perfect mortgage product.  With payment choices each month, there is a tremendous amount of flexibility for self-employed or commissioned employees. 

Business isn't always strong and it's nice to have a "minimum required payment" to help manage seasonal income fluctuations and other aberrations.

Or, for traders at the CBOT or CBOE whose income may be tied to a large year-end bonus, the ability to defer mortgage interest can be a tax planning choice.  If the annual income is small, for example, the benefits of claiming a mortgage interest tax deduction is small, too.

It may be better for traders to push deferred interest into next year and then pay their NegAm loan "current" once their income is more certain.  When that happens, the interest brought current become tax deductible in the current year.  In this manner, a trader can claim tax deductions when they are most valuable.

It could be the difference between claiming mortgage interest tax deductions from the 15% tax bracket versus the 33% tax bracket.

See, the press often assumes (wrongly) that every client in a NegAm will eventually owe more money than was originally borrowed when it's time to sell, resulting in a nasty short sale, or foreclosure.  This is a Doomsday Scenario

By contrast, there are many homeowners using negatively-amortizing mortgage products to manage their personal cash flow and to help meet their other financial objectives.

NegAm loans are not inherently evil.  They're only a problem when homeowners choose to let them be.

The information contained on The Mortgage Reports website is for informational purposes only and is not an advertisement for products offered by Full Beaker. The views and opinions expressed herein are those of the author and do not reflect the policy or position of Full Beaker, its officers, parent, or affiliates.

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