Danger of Deferred Interest Mortgages: Understanding the Risks of Negative Amortization Home Loans

Negative Amortization and Deferred Interest Mortgages Explained

Negative Amortization (Neg Am)

What It Is:

- Negative Amortization occurs when the minimum mortgage payment is less than the interest charged for the month. This causes the unpaid interest to be added to the principal balance, resulting in a loan balance that increases over time.

Interest-Only vs. Deferred Interest Loans:

- Interest-Only Loans: Payments cover only the interest, so the principal balance remains unchanged.

- Deferred Interest Loans: Payments may cover less than the interest due, leading to an increase in the loan balance (as seen with negative amortization).

Payment Option ARMs

What They Are:

- Payment Option ARMs allow for various payment choices based on different indexes like the 11th District Cost of Funds Index (COFI) or the 12-month Treasury Average (MTA). These loans offer flexibility but can lead to negative amortization if minimum payments are not sufficient to cover interest.

Pros and Cons:

- Pros: Lower initial payments can be beneficial if short-term rates are low and you expect to refinance or pay off the loan quickly.

- Cons: If interest rates rise or if you do not plan to pay off the loan in the short term, these loans can lead to higher overall costs and increased loan balances.

Considerations for Negative Amortization Loans

Equity Impact:

- Risk of Increased Balance: With negative amortization, the principal balance can grow instead of shrinking. This can lead to potential equity loss and difficulty if you need to sell your home or obtain a second mortgage.

Refinancing Risks:

- Higher Overall Costs: If current short-term interest rates are high, refinancing from a fixed-rate loan to a deferred interest mortgage might not be cost-effective.

Usage Scenarios:

- Investment Properties: These loans might be suitable if you have multiple mortgages or need flexibility in cash flow.

- Self-Employed Individuals: For those with variable income, the option to make lower payments during cash flow shortages can be advantageous.

Expert Advice:

- Henry Savage's Insights: As noted by Henry Savage, the impact of deferred interest on the loan balance can be substantial, and these loans are generally not recommended unless specific conditions apply. Always consider whether a fixed-rate mortgage might be more stable and predictable.

Key Takeaways

1. Evaluate Your Financial Situation: Before choosing a deferred interest mortgage, ensure you understand how it will affect your loan balance and overall financial health.

2. Consider Fixed-Rate Alternatives: For long-term stability, a fixed-rate mortgage might be a better choice, especially if interest rates are rising.

3. Consult a Professional: Talk to a mortgage advisor to weigh the pros and cons based on your unique circumstances and long-term financial goals.

Understanding the implications of negative amortization and deferred interest loans is crucial for making informed decisions about your mortgage.