Negative Amortization

The speaker suggests that the next wave of monetary system failure will be in the Option ARM and Alt-A loan market.  He suggests that this market will suffer more defaults than the sub-prime market has already suffered. 

While sub prime resets are shrinking as time moves forward, Option ARMs (such as negative amortization loans) and Alt-A resets are substantially increasing out to 2011.  The speaker believes that there will be much more pain as the asset bubble bursts.  However, he believes that Wall Street has figured this out and priced in this bad news.  He suggests that corporate america is on sale.

The speaker provides an explanation of what a negative amortization loan is.  He mentions that they keep your monthly payments low by increasing your outstanding loan balance up to maximum limit.  These loans are commonly referred to as payment option ARMS or neg am loans.  He suggests that this loan can be a good program if you completely understand how it works.  Many small business owners who need to control their cash flow will use programs such as these.  During the home price boom, many investors would use a negative amortizing loan to keep their carrying costs low in anticipation of increasing home values.

A negative amortization loan is a type of loan which lowers monthly payments below the amount required to cover the costs associated with that loan.  Borrowers will get involved with a negative am loan for one of two reasons; they lack the funds to make the monthly payments using traditional mortgages or they have an expectation that home prices will substantially appreciate over the next few  years. 

Negative amortization is provided as a short term solution; this type of loan is not offered past a period of 5 years.  Therefore, at the end of the 5th year, the borrower's loan will be recasted or reset to a fully amortizing loan schedule if the loan amount reaches above a maximum LTV (loan to value).

The difference between the interest owed on the loan and the monthly payment that is made is referred to as the negative balance.  The negative balance each month will be added back to your outstanding principal balance; essentially the lender is increasing your loan balance each month.  For example, assume you have a $250,000 mortgage at 6%.  Your monthly Principal + Interest payment would be $1498.88.  A negative amortization loan may only require you to make a $1,000 monthly payment each month, leaving you with a $498.88 negative balance each month.  Therefore, the following month, your outstanding loan balance will become $250,498.88.  Now, this number will continue to increase each month; and on top of that, your interest payments will consequently be higher each month to account for the increase in the outstanding loan balance that you owe.

Once the outstanding principal balance, or outstanding loan, on the property reaches the threshold LTV, 110% up to 125% for certain products, the lender will recast the loan to prevent the balance from increasing any further.  Upon recasting the loan, the lender will require fully amortizing monthly payment of principal plus interest on the outstanding balance (note:  this payment will be substantially higher than the existing neg am payment).  If the LTV threshold is achieved before 5 years, the payments will become interest-only payments until the loan is recasted. 

Conclusion

The negative amortization loan is the riskiest loan you can take.  With the credit crisis of 2008, lenders have tightened up the lending requirements substantially to prevent borrowers from engaging in more risky behavior which can lead to defaulting on their mortgage payment.  The reality of the situation is that Neg Am loans are a short term fix for those who are struggling and by borrowing with neg am, the borrower will need to make drastic strides in their income to be able to afford the payments once the loan recasts.

Be weary of low "teaser" rates that are advertised.  The saying in life "if it looks too good to be true, then it probably is", holds true here.  Many of their advertisements are deceptive and many lenders' do not take the time to truly explain the impacts of this type of loan to their borrowers.  If you decide to take this route, due your due dilligence and then do it again.  Read the fine print.