A friend of mine called to inform me he had gotten some great news in the mail. He received a letter from a lender in California informing him they would give him a $310,000 mortgage and his monthly payment would only be $999! “Think of the house I could buy,” he told me excitedly! Wow! What am I waiting for?”
I am a big fan of low rate fixed mortgages and I was very suspicious the kind of mortgage he was talking about was not one. So, I told him to bring his letter to me and we could figure out exactly what he could qualify for. Instead, he invited me to his house. I thought it was a good idea because he has a billiard table and it might be some consolation to him, that as I was putting his dream of living in a mansion on hold, he would be annihilating me at 8-ball.
A Negative Amortization Mortgage
I came to his house prepared. I found out that a $310,000 mortgage for 30 years with a $999 monthly payment is a 1% interest mortgage. Then, when I read the proposal he had received, it was as I had expected. What this letter was offering was a negative amortization mortgage.
I had to read some very small print but after I did, here’s what I found out. Once you close on the $310,000 mortgage, you have up to three years in which they will accept a minimum monthly payment of only $999. During these three years, regardless of what you’re paying, the mortgage is a 7% mortgage.
In order to amortize normally, or be paid off normally, a $310,000 mortgage at 7% for 30 years requires a monthly payment of $2,062.44. This $2,062.44 includes interest and principal. In the early stages of a negative amortization mortgage, no principal is paid. The entire payment goes toward paying the interest on the loan.
The interest due on the first payment of this loan is $1,808.33. Since the payment will be $999, $809.33 ($1,808.33-$999) will be added to the principal. Since this mortgage will have a principal that is increasing instead of decreasing, it is what is known as a negative amortization mortgage.
Now, you pay!
With the terms of this mortgage, it would accumulate $32,316.76 more debt over 3 years, which when added to the $310,000 original mortgage, totals $342,316.76 principal owed. When the negative amortization period of the mortgage ends, the mortgage becomes a regular mortgage. In this case, that happens after 3 years. Then, there is 27 years left to pay the $342,316.76 owed at 7 %. This would take a monthly payment of $2,354.51. A far cry from $999 a month!
There are many different variations of negative amortization mortgages, but this example gives you an idea of how they work. Lately, it seems that the most fashionable type of negative amortization mortgage uses a 40-year term. Sometimes the small payments are allowed for up to 5 years and the principal is allowed to increase up to 25% more than its original value.
The idea behind negative amortization mortgages is just to get more people to qualify for a large mortgage, even though when the negative amortization period of the mortgage ends, they may not be able to make the much higher payments.
Of course, in a perfect market, the property’s value will increase more than the amount the negative amortization mortgage will add to the principal owed. So, in this perfect market, one would gain equity in the property. Then, he could sell the property at a profit.
Watch out! Negative Amortization can blow up in your face!
If a negative amortization mortgage had not been available, he would not have been able to qualify for a large enough loan to purchase the property, and so, would not have been able to make a profit from it. This, however, is what I call dynamite speculation. Dynamite speculation is speculation that may blow-up in your face.
I would never recommend taking the risk a negative amortization mortgage presents to a borrower. He may not be able to make the large monthly obligation he will eventually have, and if the price of his property doesn’t skyrocket, he wouldn’t be able to sell his property at a profit. So he would be risking foreclosure.
As I was being creamed for the seventh game of 8-ball in a row, my friend came to the realization that a negative amortization mortgage was not right for him, and maybe, not right for anybody. He further realized that a few hours ago, he was all ready to buy a new house when he previously had not been giving any consideration to doing so. Therein lies the power of an advertisement for a negative amortization mortgage.
In the classic movie, “Smokey and The Bandit,” Sheriff Buford T. Justice strolls up to a young man who was about to strip parts from an abandoned vehicle. He told the young hoodlum to turn around and put his hands on the car. Then the lawman gave the young man a good boot in the pants and warned him, “That was an attention getter!” When you see an advertisement for a mortgage which offers a large loan with a very small monthly payment required, that too is an attention getter. So beware, if you have a mortgage that is anything other than a fixed rate mortgage, after it gets your attention, it might just turn around, and like Sheriff Justice, give you a real good kick in the pants.
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