Roberta Murphy, one of my favorite San Diego real estate webloggers, wrote an article calling for stricter underwriting guidelines on negative amortization loans. I essentially agree with her but want to explain a few finer points about this financial instrument.
Let's start calling these products by their true names: deferred interest loans or negative amortization loans.
Why am I being a stickler for that? The "Option ARM" name was coined
about 8-9 years ago by Washington Mutual in order to downplay the
"negative connotations of the product's real description". Countrywide
called it the "PayOption ARM" and World Savings renamed it to the
pick-a-payment loan. Those sound nicer than "negative amortization" don't they? Thank the marketing departments of those mega lenders
for that twist.
Making the minimum payment makes perfect sense...for some people. The idea is that you "defer" the difference onto the balance of your loan and that the home appreciates more than the deferred amount. You "use the difference' to pay down higher interest debt or to invest it in a higher yielding investment than real estate.
This strategy was designed in the late 80s/early 90s in response to a SLOWING real estate market. The concept was, don't tie up your money in a slow appreciating asset (real estate) when you can invest in your "monthly cash flow difference" in the stock market....and it worked!
So, does the neg am loan make sense TODAY? Probably now more than ever...IF...the vehicle is used correctly (pay down debt or beef up savings/investment). Will Southern California real estate appreciate at a rate greater than 4-5% a year for the next ten years? Probably not.
Does it make sense to refinance this loan every three years and "reset" the start rate? Well, sure IF...you are "using" the difference for high-interest debt or investment. You can refinance these loans with no closing costs when a pre-payment penalty is applied. The yield spread premium, paid to the originator, is generous enough for originators to apply it to the closing costs and still earn a respectable (and earned) commission.
Let me give you an example:
A client pays $700,000 for a home in Carlsbad, CA that should be worth $1,000,000 in 10 years. I secure that client a neg am loan for $630,000 and refinance that loan two times (at no closing costs) to keep his cash flow free to "invest". The client will have deferred that monthly savings onto the balance of the loan; the balance would have grown to $850,000.
The client would have DOUBLED his equity (he put $70,000 down) to $150,000. He would have an investment account of about $400,000 at the end of 10 years. Net result: profit of $550,000
Had he obtained a 30-year fixed rate loan at 6.5%, he would have paid the balance down to $530,000. He would have a lot of equity but he would be cash-poor. Actually, he'd have no cash. Those cash reserves can come in handy if he loses his job.
Should the client lose his jog, that 30 year fixed payment would be brutal; the client would probably run to the first job offer he received. With cash reserves, he can be patient to wait for the right job. He would have risked foreclosure if he had to continue with the fixed rate loan.
The loan is a great loan...WHEN used correctly. It's not treacherous, the originator who recommends it to an unsuspecting or financially unsuitable client is treacherous.
READ: ARMs Don't Cause Foreclosures, Loan Hacks Cause Foreclosures
The neg am loan is a fully-automatic, supercharged cannon in the wrong hands. Used properly, it's firepower can catapult you to financial security.