Negative Amortization Loan Issues on Investment Property

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Read your article on negative arm loans, and for the person who only owns a residence and most real estate investors it will not work. I own several properties, and the parcel to be refinanced is ocean front...so is going up in value more than the negative arm would be when refinanced after prepay penalty period. Cash out would be used to pay off other mortgages, thereby increasing my cash flow for a few years. Does your advice against negative arms apply in my situation?

I believe he's referring to this article.

This is actually an excellent question, and the answer is ... maybe. At least it is not a clear "no", unlike so much of what the Negative Amortization loan is misused for. This largely goes beyond the scope of what I'm trying to do with this site, but I'll take a swing at it.

The fact is that I can construct a scenario that goes either way, and the implicitly high appreciation rate you mention has surprisingly little to do with it.

The positive is that your other loans are paid off! To use Orwell-speak, this is maximum plusgood.

The negative is that this loan now includes every dollar you previously owed. Furthermore, there may be negative tax connotations to the fact that all of your interest expense now comes from one property, as opposed to being able to directly match it against individual properties with individual incomes. If interest against one property is greater than the income for that one property, you may not be able to take it all, as it's definitely a "cash-out" loan of the sort that the IRS has been limiting to partial deductibility. I'm not clear on all the implications of the tax code here (and I'd like to be educated), so consult with a CPA or Enrolled Agent. Plus it definitely becomes a full recourse loan, no matter the original circumstances.

Furthermore, your new loan won't magically create any "lake" of dollars. In order to pay off the other loans, it's going to have to be the size of all of them combined, plus any prepayment penalties, plus all costs of doing the loan, plus potential pre-payment penalties for the Negative Amortization loan.

Now consider: If you make payment option one (the "nominal" or "as if your rate was 1 percent" payment), you are allowing compound interest to work against you. This is the force Einstein described as "the most powerful force in the universe", and it's working on the whole dollar amount of every single one of your current loans and then some.

Ouch.

No matter which payment you're making, the rate you are being charged, (aka "what the money is costing you") is not fixed, but variable month to month. As far as most commercial property loans are concerned, this is no big deal. They're pretty much variable at "prime plus" anyway. However, I expect the MTA and COFI (upon which Negative Amortization loans are based) to continue rising as government borrowing increases, whereas I'm not so certain about prime.

Now with all this said, it's still very possible to construct winning scenarios, depending upon a variety of factors. You mention short-term cash flow, and that is certainly one possible justification. If short-term cash flow is all you're looking for, and the money it will cost you later on is no big deal because you're planning to buy down the prepayment penalty and sell in a short period of time. Yeah, you've added to your balance but you've got plenty of equity and you'd rather have a few hundred per month now than multiple thousands later. Think of it as a cash advance.

One of the things that negative amortization loans can do for you is make it easier for you to qualify for more loans on more properties. Because in loan qualification, the bank will only give you credit for 75 percent of prospective rents while dinging you for the full value of payments, taxes, fees, maintenance, etcetera, this can make it much harder to qualify than is realistic, given that in many markets the vacancy factor is less than five percent. You actually pay more, but you're not obligated to. Particularly because many people own investment properties for the capital gain rather than the income potential (i.e. price speculation, rather than monthly income). On the other hand, just because a property has been appreciating rapidly does not mean it will continue to do so, beachfront or not. The market nationwide is very different now than was previously. I can point to beachfront property here locally that's lost a lot of value since early 2005. Price speculation is great when it works (which is most of the time), but is really scary when it doesn't. It's a reward for risk-taking, so don't lose sight of the fact that it is a risk.

One other factor of doing this is that it can cause taxes on a sale to exceed net proceeds. Suppose you intend to sell the beachfront property in a couple of years, and it doesn't gain any more ground from where it is right now. Many properties were bought for less than 10% of their current value. Let's say you bought for ten percent of current value. If your loan is for eighty percent, and you pay six to seven percent in sale costs, you're getting ninety-three to ninety four percent of value, leaving a net of thirteen or fourteen. But you owe long term capital gains of eighty-three or eighty-four times twenty percent - almost seventeen percent! This can force you to take another loan out, against one of those "free and clear" properties lest you owe the IRS penalties. Yes, 1031 (or 1035) and even a potential personal residence exclusion can modify or nullify this, but so can all the depreciation you may have taken over the years, and if you intended to 1031 the property that would tend to contra-indicate any reasons you had for the negative amortization loan.

Now, to be honest, my experience with commercial loans is limited, and I've never done a negative amortization commercial loan. What few clients I've had in that market have had different goals in mind, and being as I'm a sustainability type loan officer, I tend to attract sustainability type clients, where Negative Amortization loans are more indicative of a speculative ("risk taker") type. I understand what's going on, but it isn't my primary approach to the issues. There are circumstances on investment properties where, unlike your primary residence, it can be very appropriate. Unfortunately, without full specifics, including time schedules, goals, reasons for holding investments, other investments, risk tolerances, etcetera, it's difficult to tell if yours is one of them. My experience in dealing with people is telling me one thing, my sense of ledger evaluation is hinting at a different answer. But I hope I've given you a clear idea of the kinds of issues you need to look at with professional help.

Caveat Emptor

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About this Entry

This page contains a single entry by Dan Melson published on March 16, 2020 7:00 AM.

Negative Amortization Loans - More Unfortunate Details was the previous entry in this blog.

Option ARMs and Cash Flow is the next entry in this blog.

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