Option ARM and Pick a Pay - Negative Amortization Loans

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(This is a republish of one of the first articles I wrote back in early summer of 2005. Everything I wrote then still applies. I am grateful that lenders have for the most part, stopped offering these, as they were always the worst sort of Make Believe loan, and expecting them to be sold on any other basis than the temporarily low payment was one of the larger examples of wishful thinking I have seen in my life. They are still legal, however, so expect them to get brought back out eventually. The disclosure requirements have been stiffened a bit, but in my opinion, not nearly enough. The body of the article is almost exactly what I wrote back then)

I am not exactly certain how to start this essay. I'm kind of in a position analogous to writing Hitler's biography in late 1940. We know at this point he's a miserable excuse for a human being, but we don't have the evidence discovered in the last four and a half years of the war as to how sick he truly was.

The negative amortization loan is in a very similar situation. It's a miserable excuse for a loan, causing a lot of damage, but we don't yet know how much. With most housing market gurus finally agreeing with what I've been saying for the last year, talking about a need for a readjustment in real estate prices, we are pretty certain that there's going to be a drastic re-evaluation of the home market soon. We are missing the data of exactly how bad it's going to be.

The negative amortization loan, with all its friendly sounding synonyms (Option ARM, Pick Your Payment, 1% loan, and variations and combinations thereof), is an idea that comes around periodically, and right now happens to be one of those times. Last time was the mid 1980s, and we had people driving their cars through the lobbies of savings and loan buildings in protest after they got hit with this loan's GOTCHA! If you see ads on the Internet or elsewhere advertising "$200,000 loan for $650 per month!" (or something similar) one of these abominations is what they're trying to hook you with.

These loans look, at first glance, to be wonderful - too good to be true. That is because they aren't true. Furthermore, given the fact that loan officers and real estate agents want to get paid, and the damage isn't apparent to the average consumer until well down the line, the unscrupulous ones sell a lot of these. I can point to loan and real estate offices where they do no other kinds of loans. Why? Because given the fact that most people shop for a loan or a home based upon the monthly payment, these are the easiest loans in the world to sell, and how many homes do you usually buy from a given real estate agent anyway? Cash flow is important, but watching only cash flow ends up in Ponzi schemes, Enron, and negative amortization loans.

I want to make very clear that yield spread is not a reason not to do a given loan. If a loan officer shops around and does the work to qualify you for a better loan on the same terms while increasing their compensation, they deserve to be paid that money. But you need to do your due diligence, also. Bottom line, no loan officer or real estate agent can rip you off without your consent. Make sure it's a better loan by making an apples to apples comparison based upon what you, the client, are actually getting. For example, if one provider is getting you a loan at 5.5%, that looks to be better than 6.5% at first glance, correct? But if the first loan is only fixed for two years, and has two points on it as well as $4000 of closing costs and a five year prepayment penalty, while the second loan is fixed for thirty years and the lender is paying all of your closing costs with no prepayment penalty, I submit that the second loan is the better loan. The negative amortization loan, piece of garbage that it is, compares favorably with no other loan available today. The yield spread varies between three and four points on these things, with most of the lenders tending towards the higher end of that spectrum in order to compete. To give you a comparison, in order to get four points of yield spread on any other type of loan, I have to stick people with an interest rate at least two full percent higher than the going rate!

Basically, what this loan does is give you three or four options for your payment every month. The lowest of these is the bank allowing you to make a payment as if your interest rate was somewhere between one and two percent, with most of them now congregating towards the lower end of the spectrum in order to compete with one another. This low rate of 1% or so IS NOT YOUR REAL RATE. IT IS NOT WHAT YOU ARE ACTUALLY BEING CHARGED! I don't know how many people I've talked to that were being taken for a ride and asked me, "Isn't there any way this is the real rate?" THE ANSWER IS NO. Let's pretend you are a bank officer. Remember, you're one sharp person, and you have another whole group of very sharp people watching what you do. If for an equivalent amount of risk, you can get about 7 percent somewhere else with a different investment, are you going to give some poor sap I mean someone you don't know a 1% loan that messes the heck out of your quarterly usage of capital bonus? Not to mention your boss's? Not on planet Earth.

The second payment option will be to make a payment based upon an interest only loan at the real rate you are being charged. I've seen the piranha that sell these loans trying to prey on each other extolling the virtues of COFI or MTA loans, depending upon which they have. The fact is that they've each got their limitations, and their upsides and downsides as opposed to the other. The problem with each and every one of these is that they are month to month variable from the beginning. There is no period where your real rate is fixed. You will never know next month's rate until it happens. Thus far in my career, I've always had loans that are fixed for three to five years, at rates lower than this rate that the loan is really charging you (and more often than not, 30 year fixed rate loans too). In other words, this second payment option is based upon a rate that changes every month, based upon the movement of an underlying index plus a margin.

The third payment option is to make an amortized payment based upon that same month-to-month rate. This is roughly analogous to a standard thirty-year loan, except that it is not fixed, and unless you make a payment of at least this much, next month's payment options are going to be worse. The fourth and final payment option given by most lenders who do these is for the client to make a fifteen-year payment. Before we move on, the point needs to be made that almost nobody actually makes the payment for either of these options, much less makes these payments habitually as opposed to the other options. These payments are higher, and are not good selling points for this loan. If the client could afford to make these payments, there are better loans to be had. This is a metaphorical fig leaf to cover their naked taking advantage of you. "Well, he could make (or could have made) this payment but didn't. It's not my fault." The reason they didn't make the payment, Mr. Unscrupulous Realtor, is because YOU told them they didn't have to. You SOLD them the house based upon the nominal payment, not the real cost. You got a bigger commission by making it look like they could afford more house than they really can. Unless they start making drastically more money at some point, they are likely to lose the house, and they may lose it anyway. I know you think it's not your problem, but some ex-client with a good lawyer is going to make it your problem.

Now, what happens if you make each of these payments? Obviously, if you make the payment for either the third or fourth option, you are paying your loan down. If you make the payment for the second option, that is basically a break-even, except that next months payments will be computed based upon one fewer month with which to pay the loan off.

What happens for 95 percent of the people who do these loans 95 percent of the time is they make payment option one. What happens in this case, where the client is making a payment that is less than the amount of interest on the loan for that month? The bank isn't going to just eat the difference. That interest has to go somewhere.

Where it goes is into the balance of the loan. This means the balance for your loan - the amount you owe the bank - goes up every month that you make this payment option. Furthermore, next month it earns interest also. Next month the difference between what you pay and what you are charged gets higher, and even more money is applied to your loan balance. You're being bit by compound interest. This is the first reason why the lenders will pay loan officers who do these loans so much. The lender knows that in the vast majority of all cases, the clients will end up owing them more money than they originally borrowed.

Furthermore, every single one of these loans that I know of has a three-year prepayment penalty. This means that even after you figure out that you've been taken for a ride, you're either still stuck with them for the rest of three years or you're going to pay a penalty amounting to thousands of dollars. Not a bad position for a lender to be in for leading you down the primrose path, is it?

I haven't even gone over recast provisions (the 1% rate, even though it's nominal, not real, doesn't last forever), and various other lurking GOTCHA!s. I hear a lot of arguments from the various lazy lowlifes who make a habit of doing these loans rationalizing what they're doing. "Those old loans had no cap. Now there's a nine percent cap" The fact is that if the client could afford six percent, there are other better loans to be doing. "They'll more than make up for it in increased equity as prices rise." Well, maybe, IF the market continues to rise, which is unlikely at the current time and never something you should bet other people's financial health upon. It's a crapshoot, at best, and the prevalence of these loans is one reason why the market is so overheated. In any event, the client is going to end up owing more money. Unless they're going to sell and not be a homeowner any more, they're going to have to pay the loan sometime, and in the meantime the longer they keep it, the worse it gets. What happens in three years if home prices are lower and the loan gets recast and now they cannot refinance out of it? Another refrain I hear from these people: "It's the only way to get them into a home!", meaning it's the only way for them to earn a commission (or, more often, the way for them to earn a bigger commission). The clients still end up owing more money at the end of the pre-payment penalty, and it'll keep getting worse the longer they keep the loan. They're still going to need to pay it back, unless they sell, and sell at a sizable profit. Furthermore, if they couldn't afford a reasonable loan in the first place when they needed to borrow $X, what makes you thing they're going to be able to afford a reasonable loan three years down the line when they owe $Y more. This is not a stable, sustainable situation for the client! Maybe in a case like this, they should continue renting. Of course, that doesn't get you a commission, does it, Mr. Unscrupulous Realtor? It certainly doesn't encourage the client to stretch beyond their means and get you a bigger commission, either, does it?

For any loan officer who does these reading this, face it: These things are a way to mess up your client who is putting money into your pocket. These put the clients into worse situations than when they started. You are betting upon factors beyond your control to save both you and them. One of these days, probably very soon, these are going to come back and bite you hard. Violation of fiduciary duty. All it takes is one of your clients getting into a bad situation who gets a good lawyer, and your career is toast along with your pocketbook.

For those of the general public reading this, I hope I've opened your eyes to some of the pitfalls of this loan. I encourage you to ask questions if you have them. But this loan is one that is designed for a narrow set of circumstances tailored around cash flow for a limited amount of time (and the one time I actually had a client who was in the situation where he could actually benefit from a negative amortization loan, none of the companies I submitted it to would approve it. This tells me that who they say it is for and what they really want are two separate things). Negative Amortization loans are abused by being misapplied because it's such an easy loan to sell to those who do not understand the way they work, and all because people shop for a loan based upon payment. So don't shop for a loan based upon payment. And if anyone offers you one of these loans, drag them into the sunlight, drive a wooden stake through their heart, and RUN AWAY! Somebody who offers you one of these is not your friend.

Caveat Emptor

Original here


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Rudy said:

I love the Option ARM loan. I have it on my 2nd home and its an absolute winner. Compared to a fixed rate loan my monthly savings are 1,000/month which I have been saving and my loan went $946 negative and I have saved so far this year closed to 11,000. I understand the way it works because my financial planner explained to me the negative aspects of the loan. I am a beleiver that it is a cash generating tool and a great finacial tool for anyone who is not ready for retirment or has lots of debt at high interest rates.

This is how you need to view this tool. Imagine that there was a loan that would let you take a few hundred dollars out of your equity on a monthly bases, knowing that equity $$ in your home earns you 0%, and your monthly paymets don't change but the few hundred dollars you take out of your equity on a monthly bases is put in a safe account such as a CD at the bank earning you around 5% today and your loan grows by the amount of $$ you take out. You can have a chance to take the lazy $$ out of your home and put it to work bringing you more and more $$ to the table.

I agree that many loan officers are selling the payment and that is wrong but as a tool for financial planning its the best program out there. Its what the rich do. Put the smallest investment with the smallest payment(monthly) to get the biggest return.

-Rudy Lasry-

Rudy, you do mention one case where the Option ARM is actually appropriate - short to medium term (3 years or less) cash flow. The problem with it is that you have the power of compound interest (which Einstein said and I agree is the most powerful thing in the universe) working against you. If you will read above, I specifically said there are circumstances it is appropriate for. However, it is very hard (if not quite impossible) to hit those circumstances with the purchase of a primary residence, especially given the current market in many parts of the country. Given the average home in this area, even an entry level buyer is going $900 per month negative, and that's with an excellent margin on the loan. I can do loans that have lower interest fixed for three to five years - even interest only - that at least puts the client in a stable situation under their control. Keep in mind that the real rate of an Option ARM is adjustable every month from the beginning of the loan. The client is never in control. Out of every 1000 Option ARMs out there, I will bet that less than ten were sold to people they were appropriate for. Back in the late 1970s and early 1980s there were people defending them much as you just did. Over 80 percent of them became non-performing loans then, in circumstances with eerie parallels to the market today.

Markus said:

I'm a mortgage broker in the State of FL, and I agree that the Pay Option ARM is not for everyone. The biggest problem with this is that we have too many people in the mortgage industry focusing on their paychecks rather than the needs of the client. And, of course, these loans pay more than any other in the form of Yield Spread.

But I agree with Rudy, when used properly, this loan can be a powerful financial planning tool. It is not to be used to help someone get the biggest, most expensive home they CAN'T otherwise afford. This should be used to help financially disciplined clients achieve their short-term financial planning goals. Cleints who want these loans simply to lower their mortgage payments should not get them.

To all of the responsible loan officers and mortgage brokers out there: my philosophy is that if a client insists on getting this loan, and you feel it is not right for them, do your best to offer them another solution. If, after that, they still insist on this loan, respectfully turn them away and let Joe Schmoe mortgage guy down the street be responsble for getting them into trouble.

But this loan is very powerful when used with investment property. It is the best way to achieve a decent monthly cash flow from shrot-term real estate investments. Most investors do sell after 5 years in order to cash out.

Regarding deferred interest - negative amortization: How much would a property have to appreciate to offset deferred interest. In most cases, it's around 2% per year. I think most markets are able to sustain an annual appreciation rate of 2%, don't you? I've never heard of a real estate market crashing. And let's look at the maximum negative am. cap and use an average cap of 115%. To reach the negative am. cap on a $200,000 loan, you would have to defer $30,000 in interest. Maybe that is possible over the course of 5 years if you make only the minimum payment, but this loan should not be kept for that long. Again, this is good for short-term financial planning.

In conclusion, this loan is for the financially disciplined, not the people who want bragging rights at the local watering hole about the really low rate they got.

You do have some good and valid points, and NegAms are far more appropriate for short term investment properties - providing the buyer knows the risks. I, however, have not only heard of real estate crashes but also seen several bubbles here in California. As I've said before, we're on the downslope of the fifth cycle I know of here in California. People have only lost 5 to 10 percent of peak value thus far, but more is extremely likely, and not only in California. I'm not certain which is worse - if you invested the difference via down payment, or if you didn't.

gudipudi said:

seems to be an interesting stuff,

my personel comment is

please try to change the appearance as it effects the reader.

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This page contains a single entry by Dan Melson published on September 27, 2021 7:00 AM.

What if Your Partner Refuses to Pay Their Share of a Loan or Mortgage (or Won't Pay on Time)? was the previous entry in this blog.

Discovering You've Got A Bad Loan - Don't Panic! is the next entry in this blog.

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