Neg-Am Loans
With the high price of real estate in Santa Cruz County and the rest of the state of California, there has been a tremendous amount of interest in very creative mortgage financing tools. The interest only mortgage is very popular, and the even more aggressive Negatively Amortized Loan is also a hot seller.
One of the most popular "Neg-Am" loans is often called a Pay Option ARM, because of the payment options offered. The first payment option is the Minimum Payment. This minimum payment is based on a Start Rate, which can begin as low as 1% for some products. The second payment option is the Interest Only payment. This is calculated based on the Index the loan is tied to, which can be the MTA, LIBOR, COFI or other index, and the margin. In many Pay Option loans, the indices can change up or down at any time, but the margin will remain fixed. The index and the margin are added together to create the Fully Indexed rate, used for the Interest Only rate. So, there can be a substantial difference between the Minimum Payment and the Interest Only Payment.
For example, let's imagine a scenario where John Borrower borrows $500,000 on a 1% Pay Option Monthly Adjustable ARM, that is based on the MTA index, today at 2.633%, plus a margin of 2.5%. The Minimum Payment, at 1%, is $1,608.20 per month. The Interest Only payment is based on the Fully Indexed rate, or MTA Index of 2.633, plus 2.5%. The Interest Only payment is therefore calculated at 5.133%, and the payment is $2,138.75 per month. The difference between the Minimum Payment and the Interest Only payment is $530.55. This amount is Deferred Interest, and will be added back to the principal balance. So, if the MTA Index remained fixed in place, which it will not, John would grow his principal by $6,366.60 in one year.
The Index in many Pay Option products can change at any time, so in this case, if the MTA rises, the difference between the Minimum Payment and the Interest Only payment would rise, creating a greater amount of deferred interest.
Many Pay Option loans are structured to have a 7.5% increase to the minimum payment each year after the first year. So, on the above example, John's minimum payment would be $1,608.20 for the first year, then $120.62 higher the second year for a payment of $1,728.82, then $129.66 higher the third year for a payment of $1,858.48, and so forth. This does not imply an increase to the rate; it simply limits the amount of deferred interest allowed.
Many Pay Option loans have a 3rd and 4th payment option, a 30 year and a 15 year Amortized payment, paying off the loan in 30 or 15 years, respectively. The Interest rate on these is the Fully Indexed rate. For the example above, that would be a 30 year payment on $500,000 at 5.133%, or $2,724.90 per month.
Negatively Amortized loans are an extremely creative financing tool, and should only be entered into with eyes wide open. Any borrower considering one should seek an experienced, ethical Mortgage Professional to guide them through the realities of this loan.