Arguably one of the most infamous mortgages to come out of the housing crisis that caused the Great Recession was the pay option arm, which allowed for negative amortization.
It single-handedly brought down some very storied and large financial institutions, including Bear Stearns, Washington Mutual, and countless others.
The combination of falling home prices mixed with the toxicity of a negative-amortizing mortgage wreaked havoc on the entire financial system like we had never seen before.
Let’s learn why.
What Is Negative Amortization?
To better comprehend negative amortization, we first have to understand basic loan amortization, which is defined as the repayment of debt via regular payments of principal and interest.
So once you take out your home loan, you make a monthly payment for a set period of time, known as the term, until the debt is fully extinguished.
Those payments consist of interest, which is what the bank or loan servicer earns, and principal, which is the actual payoff of the underlying debt.
This is how most mortgages work, and it’s generally a good thing because over time you owe less to the bank, and own more of your home.
Now let’s tackle negative amortization, which as the name implies, works counter to amortization.
Instead of paying down debt over time and owing less to the bank, a mortgage with negative amortization actually accrues interest.
Negative Amortization Example
For example, if you take out a $250,000 mortgage that allows for negative amortization, and elect to make a monthly payment that is less than the interest due, that interest is piled on top of the outstanding balance.
The fully-amortized monthly payment on a $250,000 30-year fixed-rate loan with a 4% mortgage rate would be $1,193.54.
Of that total amount, $833.33 would go toward interest, with the remaining $360.21 going toward principal repayment.
The common pay option ARM that was prevalent in the early 2000s gave homeowners four payment options.
- 30-year fully-amortizing payment
- 15-year fully-amortizing payment
- Interest-only payment
- 1% minimum payment
Guess which payment most homeowners made each month? Yep, you’re right. The 1% minimum payment.
Unfortunately, this payment, $804.10 in our example, doesn’t even satisfy the minimum amount of interest due.
As a result, the difference is added onto the outstanding balance. This means the borrower owes even more interest the following month.
If they stick with the 1% payment each month, interest will continue to accrue, and they’ll owe interest on top of interest.
Homeowners could repeat this cycle until reaching a certain level of negative equity, such as 120% LTV based on the original property value.
At that point, they’d need to begin making at least the interest-only payment each month until that option eventually disappeared as well, usually after 10 years.
Then they’d be faced with making the 30-year fully-amortizing payment on a larger outstanding balance than where they began.
So they might owe $260,000 with just 20 years remaining on the loan term, which would result in a monthly payment of $1,575.55.
In other words, a payment of roughly double what the homeowner was accustomed to making each month.
This payment shock explains why the CFPB banned negative amortization under the Qualified Mortgage rule.
Not only were homeowners faced with possibly unmanageable payments, but they also had no home equity at their disposal to allow for a refinance to better terms.
They also couldn’t sell their homes if facing payment problems, as they’d still owe the bank more than the sales price in many cases.
Do Mortgage Lenders Still Offer Neg-Am Loans?
To our knowledge, no lenders offer neg-am loans, not even non-QM lenders, though maybe somewhere out there a bank is cooking one up.
It’s doubtful this type of mortgage will return to market as it was the worst offender in the toxic home loan lineup.
Many financial pundits take issue with interest-only mortgages, so neg-ams are even more egregious in their eyes.
Chances are you won’t find one, and that’s probably a good thing.
While these loans might have had their place at one time, they are very complicated mortgages reserved for only the savviest money managers.
And that is certainly not the average American homeowner.
(flickr photo: Alcino)