With home real-estate values soft or sagging in the majority of markets nationwide, mortgage-industry experts are warning consumers to stay away from one of the most popular forms of financing left over from the go-go 1980s: mortgages with negative amortization.
Negative amortization means a buildup of debt during the term of a mortgage, rather than debt reduction. Widely used in fixed-rate graduated-payment mortgages and adjustable-rate loans, negative amortization allows a borrower to pay an artificially low rate, and to add the deferred payments onto the principal owed to the lender. Final payoff of the full debt normally isn't required until the house is sold or the mortgage refinanced.
By permitting negative amortization, lenders create more "affordable" financing packages. Say you want to refinance your loan in order to pull money out of your home equity. Your monthly payment on $100,000 at 10.5 percent would be $915. But with a 7.5 percent graduated-payment feature using negative amortization, you'd pay only $700 a month for a set period of years. The extra $215 a month would be added to your $100,000 principal debt.
Critics of mortgage-lending practices say that widespread use of negative amortization was acceptable in the 1980s, when homes in most parts of the country were appreciating in value. But the housing economics of fall 1990 -- with values flat and a recession looming -- make negative amortization a seductive trap for the unwary.
Yet new loan volume using negative amortization may be increasing, according to David Hershman, a regional vice president for the national mortgage-banking firm of American Residential Mortgage Corp. Refinancings with negative amortization are particularly hot.
"I suspect in many cases the borrowers really don't understand what they're signing up for -- even though the negative amortization feature is fully disclosed," Hershman said. "They look at the low payment, they look at the low rate, and they assume they're getting the best deal in town."
But Hershman and other mortgage-industry critics argue that such loans have become the worst deal in town. Here's a hypothetical example of what can happen in the 1990s that rarely occurred in the 1980s.
A consumer refinances a home with a $200,000 negative amortization adjustable-rate mortgage. The house is appraised at $225,000. The loan carries highly attractive terms: a 10.5 percent note rate with a 7.5 percent payment rate.
That translates to a monthly principal and interest payment of just $1,398.42, instead of the $1,829.48 required by the 10.5 percent actual note rate. Negative amortization comes to $431.06 every month, or $5,172.72 every year.
The refinanced house, however, is located in a market experiencing a moderate deflation in home values. In a two-year period, its appraised resell value declines by 10 percent. Rather than $225,000, it's now worth $202,500. But thanks to negative amortization, the principal debt against the house has risen to $210,345 -- that's $7,845 more than its market value.
But that's only part of the problem. Tack on the typical 10 percent transaction cost of selling the house -- for brokerage commissions and closing charges -- and the hapless borrower would have to bring $28,000 to the settlement table just to get out of his mortgage.
The riskiest negative amortization loans in the market today might be adjustables. Many of them are tied to a "cost-of-funds" index employed by California-based savings and loans, and carrying no rate caps to guard against big annual jumps in interest charges. The underlying theory of those loans is that the "cost-of-funds" rate index is so stable and slow moving that homeowners face little risk of payment shock.
But that theory may no longer be sound. Unlike the 1980s, according to Hershman, the cost-of-funds index is now "significantly more volatile." Last year, the index exhibited 68 percent of the volatility of one-year Treasury bills. That's up from just 27 percent in 1982.
The point here is that negative amortization loans with little or no protection against rate run-ups may sink innocent borrowers even faster than graduated-payment plans.
What are the alternatives to negative amortization for refinancers or buyers looking for low payment rates?
First, consider five-year adjustables, carrying one-half to three-quarters of a percentage point lower rates than standard 30-year, fixed-rate loans. Currently, they're available at 9.5 to 9.625 percent, plus an average two to three points, in many markets. Each point is 1 percent of the loan amount, payable at closing.
Second, there are graduated-payment plans without negative amortization. They are widely available and offer rates as low as 6 percent in the first five to seven years, followed by higher payments in later years.
Whatever low-payment loan you look at, make sure you focus on the truth-in-lending disclosure. If the mortgage permits -- or requires -- negative amortization, think long and hard before signing up. In a flat market with rising rates, your home could be eaten up by negative amortization.