Negative amortization
Encyclopedia
In finance
, negative amortization, also known as NegAm, deferred interest or graduated payment mortgage
, occurs whenever the loan payment for any period is less than the interest charged over that period so that the outstanding balance of the loan increases. As an amortization
method the shorted amount (difference between interest and repayment) is then added to the total amount owed to the lender. Such a practice would have to be agreed upon before shorting the payment so as to avoid default on payment. This method is generally used in an introductory period before loan payments exceed interest and the loan becomes self-amortizing. The term is most often used for mortgage loan
s; corporate loans which have negative amortization are called PIK loan
s.
Amortization refers to the process of paying off a debt (often from a loan or mortgage) over time through regular payments. A portion of each payment is for interest while the remaining amount is applied towards the principal balance. The percentage of interest versus principal in each payment is determined in an amortization schedule
.
is then capitalized monthly into the outstanding principal balance. The result of this is that the loan balance (or principal) increases by the amount of the unpaid interest on a monthly basis. The purpose of such a feature is most often for advanced cash management and/or more simply payment flexibility, but not to increase overall affordability.
Neg-Ams also have what is called a recast period, and the recast principal balance cap is based on Federal and State legislation. The recast period is usually 60 months (5 years). The recast principal balance cap (also known as the "neg am limit") is usually up to a 25% increase of the amortized loan balance over the original loan amount. States and lenders can offer products with lesser recast periods and principal balance caps; but cannot issue loans that exceed their state and federal legislated requirements under penalty of law.
A newer loan option has been introduced which allows for a 40-year loan term. This makes the minimum payment even lower than a comparable 30-year term.
This loan is written often in high cost areas, because the monthly mortgage payments will be lower than any other type of financing instrument.
Negative amortization loans can be high risk loans for inexperienced investors. These loans tend to be safer in a falling rate market and riskier in a rising rate market.
Start rates on negative amortization or minimum payment option loans can be as low as 1%. This is the payment rate, not the actual interest rate. The payment rate is used to calculate the minimum payment. Other minimum payment options include 1.95% or more.
s (ARMs), meaning that they are fixed for a certain period and adjust every time that period has elapsed; e.g., one month fixed, adjusting every month. The NegAm loan, like all Adjustable Rate Mortgages, is tied to a specific financial index which is used to determine the interest rate based on the current index and the margin (the markup
the lender charges). Most NegAm loans today are tied to the Monthly Treasury Average, in keeping with the monthly adjustments of this loan. There are also Hybrid ARM loans in which there is a period of fixed payments for months or years, followed by an increased change cycle, such as six months fixed, then monthly adjustable.
The Graduated Payment Mortgage
is a "fixed rate" NegAm loan, but since the payment increases over time, it has aspects of the ARM loan until amortizing payments are required.
The most notable differences between the Traditional Payment Option Arm and the Hybrid Payment Option Arm are in the start rate also known as the "minimum payment" rate. On a Traditional Payment Option Arm, the minimum payment is based on a principal and interest calculation of 1% - 2.5% on average.
The start rate on a Hybrid Payment Option Arm is higher, yet still extremely competitive payment wise.
On a Hybrid Payment Option Arm, the minimum payment is derived using the "interest only" calculation of the start rate. The start rate on the Hybrid Payment Option arm typically is calculated by taking the Fully Indexed Rate (Actual Note Rate), then subtracting 3%, which will give you the start rate.
Example: 7.5% fully indexed rate - 3% = 4.5% (4.5% would be the start rate on a Hybrid Pay Option Arm)
This guideline can vary among lenders.
Aliases the Payment Option Arm loans are known by:
borrowers do not need to make payments on their loan until it is due. A reverse mortgage is due only when the borrower no longer resides in his or her principal residence.
In a very hot real estate market a buyer may use a negative-amortizing mortgage to purchase a property with the plan to sell the property at a higher price before the end of the "negam" period. Therefore, an informed investor could purchase several properties with minimal monthly obligations and make a great profit over a five-year plan in a rising real-estate market.
However, if the property values decrease, it is likely that the borrower will owe more on the property than its worth, known colloquially in the mortgage industry as "being underwater." In this situation, if the property owner cannot make the new monthly payment, he or she may be faced with foreclosure or having to refinance with a very high loan-to-value ratio, requiring additional monthly obligations, such as mortgage insurance, and higher rates and payments due to the adversity of a high loan-to-value ratio.
It is very easy for borrowers to ignore or misunderstand the complications of this product when being presented with minimal monthly obligations that could be from one half to one third what other, more predictable, mortgage products require.
. A Negative Amortization Mortgage is a mortgage where the principal increases throughout the early stage of the mortgage. This early stage is known as the negative amortization or negam period. During this time period the borrower is, in effect, making partial payments toward his mortgage. The remainder of his payment, which he is not paying, is added on to the amount owed on the mortgage. Naturally, when this period ends, he must start to pay this additional amount off, along with his original principal.
A Reverse Mortgage
happens when a homeowner, usually a retired person, sells some or all of his equity in his home and retains the right to live there. No payments are due until the homeowner sells the house, moves out of the house, or dies. However, all the interest charged on the loan is applied back to the principal, since no interest payments are made during the life of the loan.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, negative amortization, also known as NegAm, deferred interest or graduated payment mortgage
Graduated payment mortgage loan
A graduated payment mortgage loan, often referred to as GPM, is a mortgage with low initial monthly payments which gradually increase over a specified time frame. These plans are mostly geared towards young men and women who cannot afford large payments now, but can realistically expect to do...
, occurs whenever the loan payment for any period is less than the interest charged over that period so that the outstanding balance of the loan increases. As an amortization
Amortization
Amortization is the process of decreasing, or accounting for, an amount over a period. The word comes from Middle English amortisen to kill, alienate in mortmain, from Anglo-French amorteser, alteration of amortir, from Vulgar Latin admortire to kill, from Latin ad- + mort-, mors death.When used...
method the shorted amount (difference between interest and repayment) is then added to the total amount owed to the lender. Such a practice would have to be agreed upon before shorting the payment so as to avoid default on payment. This method is generally used in an introductory period before loan payments exceed interest and the loan becomes self-amortizing. The term is most often used for mortgage loan
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
s; corporate loans which have negative amortization are called PIK loan
PIK loan
A PIK loan is a type of loan which typically does not provide for any cash flows from borrower to lender between the drawdown date and the maturity or refinancing date, not even interest or parts thereof , thus making it an expensive, high-risk financing instrument...
s.
Amortization refers to the process of paying off a debt (often from a loan or mortgage) over time through regular payments. A portion of each payment is for interest while the remaining amount is applied towards the principal balance. The percentage of interest versus principal in each payment is determined in an amortization schedule
Amortization schedule
An amortization schedule is a table detailing each periodic payment on an amortizing loan , as generated by an amortization calculator. Amortization refers to the process of paying off a debt over time through regular payments...
.
Defining characteristics
Negative amortization only occurs in loans in which the periodic payment does not cover the amount of interest due for that loan period. The unpaid accrued interestAccrued interest
In finance, accrued Interest is the interest that has accumulated since the principal investment, or since the previous interest payment if there has been one already. For a financial instrument such as a bond, interest is calculated and paid in set intervals...
is then capitalized monthly into the outstanding principal balance. The result of this is that the loan balance (or principal) increases by the amount of the unpaid interest on a monthly basis. The purpose of such a feature is most often for advanced cash management and/or more simply payment flexibility, but not to increase overall affordability.
Neg-Ams also have what is called a recast period, and the recast principal balance cap is based on Federal and State legislation. The recast period is usually 60 months (5 years). The recast principal balance cap (also known as the "neg am limit") is usually up to a 25% increase of the amortized loan balance over the original loan amount. States and lenders can offer products with lesser recast periods and principal balance caps; but cannot issue loans that exceed their state and federal legislated requirements under penalty of law.
A newer loan option has been introduced which allows for a 40-year loan term. This makes the minimum payment even lower than a comparable 30-year term.
Typical Circumstances
All NegAM home loans eventually require full repayment of principal and interest according to the original term of the mortgage and note signed by the borrower. Most loans only allow NegAM to happen for no more than 5 years, and have terms to "Recast" (see below) the payment to a fully amortizing schedule if the borrower allows the principal balance to rise to a pre-specified amount.This loan is written often in high cost areas, because the monthly mortgage payments will be lower than any other type of financing instrument.
Negative amortization loans can be high risk loans for inexperienced investors. These loans tend to be safer in a falling rate market and riskier in a rising rate market.
Start rates on negative amortization or minimum payment option loans can be as low as 1%. This is the payment rate, not the actual interest rate. The payment rate is used to calculate the minimum payment. Other minimum payment options include 1.95% or more.
Adjustable Rate Feature
NegAM loans today are mostly straight Adjustable Rate MortgageAdjustable rate mortgage
A variable-rate mortgage, adjustable-rate mortgage , or tracker mortgage is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets. The loan may be offered at the lender's standard variable...
s (ARMs), meaning that they are fixed for a certain period and adjust every time that period has elapsed; e.g., one month fixed, adjusting every month. The NegAm loan, like all Adjustable Rate Mortgages, is tied to a specific financial index which is used to determine the interest rate based on the current index and the margin (the markup
Markup (business)
Markup is the difference between the cost of a good or service and its selling price. A markup is added on to the total cost incurred by the producer of a good or service in order to create a profit. The total cost reflects the total amount of both fixed and variable expenses to produce and...
the lender charges). Most NegAm loans today are tied to the Monthly Treasury Average, in keeping with the monthly adjustments of this loan. There are also Hybrid ARM loans in which there is a period of fixed payments for months or years, followed by an increased change cycle, such as six months fixed, then monthly adjustable.
The Graduated Payment Mortgage
Graduated payment mortgage loan
A graduated payment mortgage loan, often referred to as GPM, is a mortgage with low initial monthly payments which gradually increase over a specified time frame. These plans are mostly geared towards young men and women who cannot afford large payments now, but can realistically expect to do...
is a "fixed rate" NegAm loan, but since the payment increases over time, it has aspects of the ARM loan until amortizing payments are required.
The most notable differences between the Traditional Payment Option Arm and the Hybrid Payment Option Arm are in the start rate also known as the "minimum payment" rate. On a Traditional Payment Option Arm, the minimum payment is based on a principal and interest calculation of 1% - 2.5% on average.
The start rate on a Hybrid Payment Option Arm is higher, yet still extremely competitive payment wise.
On a Hybrid Payment Option Arm, the minimum payment is derived using the "interest only" calculation of the start rate. The start rate on the Hybrid Payment Option arm typically is calculated by taking the Fully Indexed Rate (Actual Note Rate), then subtracting 3%, which will give you the start rate.
Example: 7.5% fully indexed rate - 3% = 4.5% (4.5% would be the start rate on a Hybrid Pay Option Arm)
This guideline can vary among lenders.
Aliases the Payment Option Arm loans are known by:
- Negative Amortizing Loan (Neg Am)
- Pick - A - Pay
- Deferred Interest Option Loan (This is the way this loan was introduced to the mortgage industry when first created)
NegAm - Mortgage Terminology
- Cap
- Percentage rate of change in the NegAm payment. Each year, the minimum payment due rises. Most minimum payments today rise at 7.5%. Considering that raising a rate 1% on a mortgage at 5% is a 20% increase, the NegAm can grow quickly in a rising market. Typically after the 5th year, the loan is recast to an adjustable loan due in 25 years. This is for a 30 year loan term. Newer payment option loans often offer a 40 year term with a higher underlying interest rate.
- Life Cap
- The maximum interest rate allowed after recast according to the terms of the note. Generally most NegAm loans in the last 5 years have a life cap of 9.95%. Today many of these loans are capped at 12% or above.
- Index
- The variable, such as the COFI; COSI; CODI or often MTA, which determines the adjustment as an increase or decrease in the interest rate.other examples include the LIBOR and TREASURY
- Margin
- Often disclosed in the Adjustable Rate Rider of a Deed of Trust, the Margin is determined by the lender and is used to calculate the interest rate. Often the Loan Originator can increase the margin when structuring the product for the borrower. An increase to the Margin will also increase the borrower's interest rate, but will improve the Yield Spread PremiumYield spread premiumA yield spread premium is the money or rebate paid to a mortgage broker for giving a borrower a higher interest rate on a loan in exchange for lower up front costs, generally paid in Origination fees, Broker fees or Discount Points...
which the Loan Originator may receive as compensation from the lender.- F.I.R
- The Fully Indexed Rate is the sum of the Margin and the current Index value at the time of adjustment. The F.I.R. is the "interest rate" and determines the Interest Only, 30 year and 15 year amortized payments. Most Adjustable Rate products have caps on rate adjustments. If the note provides for a single adjustment not to exceed an increase by more than 1.5, and the variable Index, for example, increased by 2.5 since the last adjustment, the Fully Indexed Rate will top out at a max adjustment of 1.5, as stated in the note, for that particular adjustment period. Often the F.I.R. is used to determine the Debt to Income Ratio when qualifying a borrower for this loan product.
- Payment Options
- There are typically 4 payment options (listed from highest to lowest):
-
- 15 Year Payment
-
- Amortized over a period of 15 years at the F.I.R.
- 30 Year Payment
- Amortized over a period of 30 years at the F.I.R.
- Interest Only Payment
- F.I.R. times the principal balance, divided by 12 months (with no amortization or reduction in the owed balance).
- Minimum Payment
- Based on the minimal Start Rate determined by the lender. When paying the Minimum Payment, the difference between the Interest Only Payment and the Minimum Payment is deferred to the balance of the loan increasing what is owed on the mortgage.
- Period
-
- How often the NegAm payment changes. Typically, the minimum payment rises once every twelve months in these types of loans. Usually the rate of rise is 7.5%. The F.I.R. is subject to adjusting with the variable Index, most often on a monthly basis, depending on the product.
- Recast
- Premature stop of NegAm. Should the balance increase to a predetermined amount (from 110% up to 125% of the original balance per Federal or State regulations) the loan will be "recast" with one of two payment options: the fully amortized principal and interest payment, or if the maximum balance has been reached before the fifth year, an interest only payment until the loan has matured to the recast date. (typically 5 years)
- Stop
- End of NegAm payment schedule
Types
In a reverse mortgageReverse mortgage
A remortgage is a form of equity release available in the United States. It is a loan available to seniors aged 62 or older, under a Federal program administered by HUD. It enables eligible homeowners to access a portion of their equity...
borrowers do not need to make payments on their loan until it is due. A reverse mortgage is due only when the borrower no longer resides in his or her principal residence.
Criticisms
Negative-amortization loans, being relatively popular only in the last decade, have attracted a variety of criticisms:- Unlike most other adjustable-rate loans, many negative-amortization loans have been advertised with either teaser or artificial, introductory interest rates or with the minimum loan payment expressed as a percentage of the loan amount. For example, a negative-amortization loan is often advertised as featuring "1% interest", or by prominently displaying a 1% number without explaining the F.I.R. This practice has been done by large corporate lenders. This practice has been considered deceptive for two different reasons: most mortgages do not feature teaser rateTeaser rateA teaser rate is a low, adjustable introductory interest rate advertised for a loan, credit card, or deposit account in order to attract potential customers to obtain the service. The teaser rates are normally too good to be true for the long term, and are far below the common realistic rate for...
s, so consumers do not look out for them; and, many consumers aren't aware of the negative amortization side effect of only paying 1% of the loan amount per year. In addition, most negative amortization loans contain a clause saying that the payment may not increase more than 7.5% each year, except if the 5-year period is over or if the balance has grown by 15%. Critics say this clause is only there to deceive borrowers into thinking the payment could only jump a small amount, whereas in fact the other two conditions are more likely to occur. - Negative-amortization loans as a class have the highest potential for what is known as payment shock. Payment shock is when the required monthly payment jumps from one month to the next, potentially becoming unaffordable. To compare various mortgages' payment-shock potential (note that the items here do not include escrow payments for insurance and taxes, which can cause changes in the payment amount):
- 30-year (or 15-year) fixed-rate fully amortized mortgages: no possible payment jump.
- 5-year adjustable-rate fully amortized mortgage: No payment jump for 5 years, then a possible payment decrease or increase based on the new interest rate.
- A 10-year interest only mortgage product, recasting to a 20-year amortization schedule (after ten years of interest-only payments) could see a payment increase of up to $600 on a balance of 330K.
- Negative amortization mortgage: no payment jump either until 5 years OR the balance grows 15% (depending on the product) higher than the original amount. The payment increases, by requiring a full interest-plus-principal payment. The payment could further increase due to interest-rate changes. However, all things being equal, the fully amortized payment is almost triple the negatively amortized payment.
- First month Free: a loan officer may allow the borrower to skip the first monthly payment on a refinance loan, by simply adding that payment to the principal and charging compound interest on it for many years. The borrower may not understand or question the transaction.
In a very hot real estate market a buyer may use a negative-amortizing mortgage to purchase a property with the plan to sell the property at a higher price before the end of the "negam" period. Therefore, an informed investor could purchase several properties with minimal monthly obligations and make a great profit over a five-year plan in a rising real-estate market.
However, if the property values decrease, it is likely that the borrower will owe more on the property than its worth, known colloquially in the mortgage industry as "being underwater." In this situation, if the property owner cannot make the new monthly payment, he or she may be faced with foreclosure or having to refinance with a very high loan-to-value ratio, requiring additional monthly obligations, such as mortgage insurance, and higher rates and payments due to the adversity of a high loan-to-value ratio.
It is very easy for borrowers to ignore or misunderstand the complications of this product when being presented with minimal monthly obligations that could be from one half to one third what other, more predictable, mortgage products require.
Difference Between Negative Amortization and a Reverse Mortgage
A Negative Amortization Mortgage should not be confused with a Reverse MortgageReverse mortgage
A remortgage is a form of equity release available in the United States. It is a loan available to seniors aged 62 or older, under a Federal program administered by HUD. It enables eligible homeowners to access a portion of their equity...
. A Negative Amortization Mortgage is a mortgage where the principal increases throughout the early stage of the mortgage. This early stage is known as the negative amortization or negam period. During this time period the borrower is, in effect, making partial payments toward his mortgage. The remainder of his payment, which he is not paying, is added on to the amount owed on the mortgage. Naturally, when this period ends, he must start to pay this additional amount off, along with his original principal.
A Reverse Mortgage
Reverse mortgage
A remortgage is a form of equity release available in the United States. It is a loan available to seniors aged 62 or older, under a Federal program administered by HUD. It enables eligible homeowners to access a portion of their equity...
happens when a homeowner, usually a retired person, sells some or all of his equity in his home and retains the right to live there. No payments are due until the homeowner sells the house, moves out of the house, or dies. However, all the interest charged on the loan is applied back to the principal, since no interest payments are made during the life of the loan.
See also
- PIK loanPIK loanA PIK loan is a type of loan which typically does not provide for any cash flows from borrower to lender between the drawdown date and the maturity or refinancing date, not even interest or parts thereof , thus making it an expensive, high-risk financing instrument...
, a similar concept in corporate financeCorporate financeCorporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...