There’s a different kind of loan on the market allowing some homeowners to purchase their dream homes, while others are using the loans as an investment strategy.
The loans, known as Payment Choice Mortgage Loans are actually negative amortization…where the principal actually increases during the life the loan.
Sounds interesting, right..
In a traditional mortgage, monthly payments usually include interest and principal. As the loan matures, the amount of interest reduces and the amount of principal paid increases.
Negative amortization or NegAm allows the homeowner to pay only a fraction of the actual interest. Any shortage is then added to the principal of the loan. The loans usually have a time limit for the partial interest payments. The banks build in a dollar-amount limit for how much the lender will allow added to the principal. The loans are usually Adjustable Rate Mortgages set to increase in yearly increments, fluctuating with prime interest. The loans have a time limit before the loans convert to a traditional mortgage.
The NegAm loans basically allow home buyers to purchase more of a home for less. Homeowners using NegAm loans are able to purchase a more expensive home with a lower monthly payment. If market home values are increasing, the buyer is less at risk. For example, in five years when the loan is set to convert, if the home has appreciated, the owner has invested a fraction of the cost and is then able to sell the home and pay-off the mortgage with a profit.
Or, some homeowners instead invest the extra cash and when the loan converts, their investment allows for a quick pay-off.
Real estate investment expert Mark Barnes shows an example, “Let's assume your mortgage has a conventional loan that calls for a monthly payment of $800. If you refinance to a negative amortization loan, your payment may go down to $400 or less, leaving you $400 or more each month to invest. Now, keep in mind, your mortgage balance is actually increasing with this loan, because you are not paying the required interest, and it is being added to your principal balance.
“The bad thing about negative amortization is that eventually, the mortgage payments may need to increase to allow the larger loan amortize over its remaining life. Thus, the increase in monthly payments can be significant.”
After the initial period of partial interest payments, any NegAm loan will convert. Keep in mind the principal is getting bigger when the loan converts, the monthly payments probably will jump significantly. If property values haven’t increased or a refinance isn’t an option, homeowners could struggle to meet the higher mortgage payments.
Another con to the NegAm loan is the Adjustable Rate nature of the loan. The increase in interest rate is usually built in yearly. Remember, these loans have a limit to the amount of interest added to the principal, usually 115% of the original loan amount, according to About.com. If interest rates jump drastically, the limit is reached prematurely, ending of the partial interest payments. Homeowner’s might face an unaffordable mortgage payment.
Seemingly, the biggest risk for homeowners is depreciation of home value. If the home’s fair market value doesn’t appreciate or the interest rate jumps higher than expected, refinancing might not be an option.