The 1% Mortgages – Are they real?
Mortgage bankers and brokers have been advertising the 1% and 2% mortgages and representing them as if they were fixed. You will see them as Option ARM’s, FlexPay ARM’s, Pick-your-payment ARM’s and other ‘creative’ titles.
It is a very creative loan because in each monthly statement you are given the option to pay your choice of 4 different payments. You can pay any one of the four, including monthly interest only, a 15 year or a 30 year amortizing payment based upon the fully indexed rate and a 4th and most scary option… a payment that is less than the interest payment that is due. If you choose this fourth option, you are deferring interest and creating what is called negative amortization.
What is negative amortization you ask? Negative amortization is what occurs anytime you pay less that the interest that is due. You are going into the hole! How good or bad is this option?
For a few borrowers (very few in my opinion) should ever choose a negative amortizing type loan program. That said, for some very savvy borrowers, it can be a good tool, if it's used properly. It gives the borrower/homeowner the opportunity to defer part of your interest payment that is currently due, out to the future to pay later.
That said, it is only a good product and financial tool if you plan on and actually pay some of the deferred interest back! If you do not pay the deferred interest...
(negative amortization) YOU ARE PAYING INTEREST ON INTEREST!
The problem is that most borrowers that have chosen a neg-am loan program rely on the lowest payment option just to keep up with their mortgage and never have the ability or intention of paying it the deferred interest unless they refinance or sell the home. Problem there is the assumption that there will be continued appreciation and increased value on their home. We all know that is no guarantee!
Now, if you are using this type program for your bigger-picture financial planning, you would use the lower monthly payments for only a short time, to pay off other consumer debts - especially if those debts have higher interest rates and are non tax-deductible.
At 1 or 2%, aren’t the payment extra low? They are… kind of ;-) You must understand that the 1% is the interest rate only for the first month to begin with. After the first month, the 1% is only a fictitious rate and is used to calculate the minimum payment and is no longer the interest rate at all!
To explain further, think this through. The payment for the first year of the loan is calculated using the 1% rate as if it were the true interest rate for any mortgage and it was amortized over 30 years. But, that is only the minimum monthly payment for the 1st year.
After the 1st month, the actual interest rate can and will jump up to a rate that is the sum total of the “index” (such as a 1 year treasury bill, LIBOR, 12 months average of the 1 year treasury bill, Cost of Funds among others), and a margin then added to that index.
Does anyone actually believe a 1% fixed rate mortgage exists? Believe it or not, some borrowers don’t realize or understand it doesn’t and buy into the lie! Advertising a 1% rate is very misleading and by some lenders, a calculated lie. Yes the borrower is allowed to make the 1% calculated payment, but that payment IS much less than the payment required to cover the principle & interest due. Thus, the resulting negative amortization or deferred interest occurs and your balance on your mortgage goes up.
There is more to pricing and the rates on these loans that you need to be aware of. All ARM’s have what is called a margin. The margin is the fixed amount added to the index (which is constantly moving) which is then used to compute the actual interest rate each month and year.
Unfortunately, most borrowers don’t know anything about margins nor do they realize the lenders are compensation based on the margin AND the higher the margin they charge the borrower, the higher they get paid. A loan officer can decide how much he or she wants to make on every loan. In the exotic mortgage programs, they can make bib money by charging you with a higher margin and it is all but invisible to the borrower. Sad but true. THAT IS PREDATORY LENDING! The loan officer sells the low payment and the borrower believes they got a great low rate loan.
The exotic loan programs do allow you to purchase more home for the same monthly payment of a much lower priced home. Lenders will offer adjustable rates that are lower than fixed rates. You as the borrower are accepting the risks of potentially rising interest rates. So, why would a borrower choose an adjustable program unless they are getting something in return?
If they are paying just the interest on a loan and no principle, they are making a lower payment. Let’s say you borrow $350,000 at 6.25% over 30 years...the regular full payment would be $2155.01. An interest only payment at 5.75% on say a 5 yr ARM is only $1677.08. That is a monthly difference of over $477! In most mortgage qualifying that represents as much as $70,000 more house! WOW! Now you can see the appeal. But if all you pay is the interest on the loan, you're not ever gaining any equity in the home! You are relying totally on the home appreciating in value to get ahead. Not a good plan long term.
Lenders have convinced borrowers that paying down principle or paying off a mortgage is not important. Equity will come from home values rising rather than the paying down principle. Yes, that's can be an easy sell when homes are appreciating 5 and 10% or more each year. But as you can see this past year or so, that is sure not guaranteed. Add to that the constant refinancing of mortgages, with the average life of a loan being around 5 years, and the borrowers seem willing to take on the greater risk. Long term, that may prove to be disasterous.
These exotic ARM’s are not very difficult to sell to many borrowers. They have been conditioned by other lending, like the auto industry, to only focus on the payment amount. The borrower gets a very low payment and the lender makes a loan that they get paid very well on. The unfortunate side is that in so, the borrower has now assumed tremendous risk when the interest rates rise. These loans are typically more profitable to the lender or broker than writing a fixed rate loan as well.
Are there borrowers that could truly be qualified for these exotic loans and can assume the additional risks? I believe so. If the borrower (you) live well with a budget, and can afford a higher payments, and just want to use your mortgage as a part of a larger financial plan, these can be a good tool. if you plan to sell the home at some point in the not to distant future, and homes are appreciating in your area consistently, then this loan may be a good choice.
The payments can be much lower than what a traditional loan payment would be and sometimes, buying time is what is what you need to do to accomplish some other need. In addition, if you have income that varies from month to month, this loan can be used to manage your cash flow, as well. But, in so you must pay the optional 15 or 30 year payments when your income is up to make up for those months when you chose to pay the interest-only or the lower optional payment or negative amortization payment during leaner months.
These exotic loans can also be great for the professional investor that is managing and measuring the returns on all their investment portfolio and they look at their mortgage as just one of their vehicles just like stocks and bonds. If they are earning say 8 to 10% on some cash investments and they are only paying 6% on the mortgage, they may see it as a better investment choice to defer interest or pay interest-only on a mortgage to enable themselves to earn the higher return on investment they are getting on their other portfolios.
In closing, we will outline where the risks are in these exotic loans. The greatest concern is in the optional payment programs. These loans have what is termed a 5 year “recast”. What this means is that after 5 years, the loan will be re-amortized to insure that the borrower pays down the loan in the remaining 25 years of that loan.
For borrowers that are paying only the minimum payment, and have been deferring interest… resulting in a greater balance due than they started with, are in for a real surprise. The minimum monthly payment could potentially increase by as much as 25 to 60%. How many typical families can absorb such an increase in their payments? I would say, next to none!
So what do they do? They will be forced to either refinance or sell their homes. What if they are living in a less than healthy, climbing real estate market? What if they are "upside down" in any equity on their home meaning they owe more than the value of their home? The scary thing is that this will more often than not, lead to foreclosures.
If there are too many foreclosures in any given market, how will that hurt the real estate values? It can be huge. If it happens in many markets over the same period of time, it can have an affect on the entire economy. Banks are not in the real estate business and don't want to own real estate either. They are often forced to dump the properties and get them off their books quickly. What if you are in an area, but you are not in trouble your self, but you need to sell your home AND your competition in the market happens to be a number of banks selling their foreclosed properties at the same time? Can you imaging the costs to you personally and you did nothing wrong?
As a last suggestion, although we could go on for days on this subject alone, be sure that the lifetime cap of no more than 9.95%. There are a few with caps above that, but there are also more than enough lenders with a 9.95% lifetime cap. As always, good luck and be carefull! Ask questions and read everything.
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