Payment Option Mortgage Loans
Home Loans with Low Start Rates are Risky in Today's Housing Market
Mar 10, 2009
Today's payment option loans are a little more sophisticated than what mortgage brokers once referred to as “neg ams”. Neg am is trade talk for negative amortization. But regardless of the increased sophistication, an option payment ARM (adjustable rate mortgage) still has the risk of negative amortization.
What Amortization Means
To amortize is to lessen the debt or principal amount. An interest only payment loan doesn't touch the principal. Thus it is a non-amortizing loan that will call or have the principal due, which is the original loan amount, after a short few years. Fifteen and 30-year amortized fixed loans have a complex formula arrangement that creates mostly interest payments for the first few years. This arrangement assures that lenders will make more in interest during the early phase of the loan before you sell or refinance.
How ARMS Work
All ARMs or adjustable rate mortgages have two basic components to determine the payments. One is the index. An index is a figure, published daily in most newspaper financial sections, that fluctuates according to the economy. The most commonly used indices are the T-Bill (Treasury Bill), the LIBOR (London International Bank Offering Rate), or the COFI (Cost Of Funds Index), also called the “coffee loan" by mortgage brokers.
Then the lender adds to that what is known as a margin.The margin is disclosed in advance, and varies from lender to lender and according to the consumer risk level. Sub-prime loans for lower credit score borrowers tend to be higher than FHA or conventional loans. But a margin is constant. It never changes. It brings the mortgage payment rate to an acceptable level for the lender's profit.
To protect the borrower, non negative amortizing ARMs have adjustment caps or limits per adjustment term and the life of the loan. You should be informed in writing of these caps. FHA and VA ARM's have the lowest margins and caps.
Negative Amortization ARMs or Payment Option Loans
A negative amortization ARM or payment option loan is more complicated and risky. All the details of an ARM, index and margin, are the same except for a couple of glaring features. Whatever lower payment is chosen or whatever teaser rate is used leaves a difference between what is paid and what should have been paid according to the actual index and margin. That difference is applied back to the principal.
Rate changes can be adjusted monthly instead of semi-annually or annually. And there may not be any caps for the adjustments. This difference, if you choose to pay the lower payments, can add up to 115% of the original loan amount. At that point, you will no longer have a lower payment option. Because your principal is now higher, your payment increases beyond what the true payment was before.
Sometimes the loan term is recast, or rescheduled after five years. Whatever the differences were prior to that are added back into the loan. So your original $200,000 loans could have been increased to $230,000 dollars principal, with less time, 25 years, to pay it off. Your payments go out the roof!
Housing Market and Economic Cycles
Neg am or payment option loans used to be less hazardous than now. Younger couples were confident of increased pay with their work. Home values were appreciating more rapidly than negative amortization could eat up the equity. Today's economy creates a challenges in both areas. As your neg am payments get higher, your pay may get lower. Constant devaluation of homes today makes owing more than what the house is worth a high probability. Very hazardous indeed.
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