What is Negative Amortization?

Think you’ve seen it all? Nope, not yet! Sound too good to be true? It is! How can they claim that? They just do! Is it magic or is it negative amortization? Duh!

Just the sound of the term negative amortization makes many people cringe and it should. It’s not because a loan with a negative amortization feature (Neg Am) is inherently bad, but rather because many borrowers simply do not understand the feature. Because of the negative connotation of this term, we believe the industry is in the process of renaming this type of loan. Nowadays, this type of loan is frequently referred to as an Option Arm. While much more pleasing to our ears, it remains the same loan and that’s fine, as long as the borrower understands how it works.

These loans became popular in the late 70’s and early 80’s when interest rates in general and mortgage rates specifically were at or near all time highs. They provided borrowers the ability to qualify for mortgages using “start rates” or “teaser rates” which were slightly below traditional market rates. These below market rates reduced the borrower’s monthly payment obligation which ultimately allowed borrowers to qualify for larger loan amounts.

Most of these loans had annual caps on monthly payment increases. These monthly payment caps were pegged at 7.50% per year, probably because salary increases were averaging somewhere in the area of 7.50% per year. So, if your salary increased by 7.50%, say from $2,000 per month to $2,150 per month or an increase of $150 per month, the assumption was that one third of your monthly income could be used for mortgage payments. A $50 per month increase in mortgage payment could be quite easily absorbed by a borrower earning an additional $150 per month……and life was good!…..until you realized that your mortgage balance was increasing rather than decreasing. Here’s how it works:

Let’s begin by demonstrating how a fully amortized loan reduces principal balance with each payment made. For this example, we will assume the following:

When the lender receives a payment of $1,264.14 a simple mathematical determination is then made as to how much interest is due and the remainder is the amount which is applied to reduce the principal balance.

At this point, the “Ending Loan Balance” after a payment has been made becomes the “Beginning Loan Balance” for the next payment received. Now, let’s calculate the interest and principal distribution for the second payment.

The next example will demonstrate how a negatively amortizing loan can increase principal balance with monthly payments made. For this example we will once again assume the same loan amount and loan term but add the teaser rate as follows:

(Note: in this example let’s assume that the adjustable interest rate is linked to the 6 month libor index plus a margin of 2.50% we will further assume that the current index value for the 6 month libor is 4.00%......when the index and margin are added together it gives us an interest rate of 6.50% which is conveniently equal to the fixed rate in the first example above.)

Beginning Loan Balance     $200,000.00 First Payment     $ 734.25 Interest Due:     Beginning Loan Balance $ 200,000.00 Annual Rate (index plus margin) _x ____.065 Annual Interest Due $ 13,000.00   Monthly Int. Due ($13,000/12).............................................. -1,083.33 Negative Amortization (int. due minus pmt. made)………………..……...................................... _____-349.09 Ending Loan Balance   $200,349.08

Once again, the “Ending Loan Balance” after a payment has been made becomes the “Beginning Loan Balance” for the next payment received. Now, let’s calculate the interest and principal distribution for the second payment.

This “Negative Amortization” process will continue until such time that the scheduled monthly payment exceeds the monthly interest due. Two factors can impact this.

First, Neg Am loans typically have an annual payment increase cap of 7.50%. This is how the annual payment cap works.

While not reasonable at all, for this example let’s assume that the interest rate remained constant at the original 6.50% per year (remember index 4.00% plus margin 2.50%) At the end of the 7th year, after 84 monthly payments, the current principal balance would exceed the original loan balance by $18, 944.03. That is, the loan balance after the 84th payment would be $218,944.03. Below you will see how much the loan balance increased at the end of each of the seven years.

The second factor influencing how long the “negative amortization” feature will last is the interest rate, both the teaser rate as well as the current rate. The lower the initial teaser rate, the longer you can expect the “negative amortization” feature will last. On the other hand, if the current interest rate dropped below the 6.50% used in our example, the “negative amortization” period would be shortened. Conversely, if interest rates increased above the 6.50%, the period would be extended. (To get a better understanding of past interest rates, see our “Historical Mortgage Rates” section of this web site.....you might be surprised!)

The “Option Arm” feature of the Neg Am loan gives the borrower monthly payment choices that are calculated and offered by the lender. Typically, the choices or options as they are referred to are the following:

Option One: This would be the minimum required monthly payment that would generate the negative amortization that was explained above.

Option Two: This would be the interest only payment that would neither increase nor decrease the current loan balance.

Option Three: This would be the payment necessary to payoff the loan in fifteen years or what remains of the fifteen year initial term. That is, after one year of payments, this option would provide you with the payment necessary to payoff the balance over the next 14 years. If two years of payments were made, the payoff would be based on 13 years and so on.

Option Four: Similar to option three, this would be the payment necessary to payoff the loan in thirty years or what remains of the thirty year initial term. That is, after one year of payments, this option would provide you with the payment necessary to payoff the balance over the next 29 years. If two years of payments were made, the payoff would be based on 28 years and so on.

To further illustrate the payment option feature, let’s once again return to our earlier examples and assume that two years (24 pmts.) and four years (48 pmts.) of payments were made……The monthly mortgage statements from a lender might look like this:

While we’re optimistic that this discussion of “Negative Amortization” will give you a better understanding of this concept, it does not cover all aspects. If you currently have a Neg Am loan and do not fully understand it, we would encourage you to contact one of our agents who would be happy to help you understand your loan. On the other hand, if you are contemplating a Neg Am loan, we would also like to hear from you for several reasons, initially, to insure that you understand the full impact of a Neg Am loan and secondly, to explore other loan options that might better suit your financial needs.

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