From the number of emails I get, I realize that people are really confused about interest only loans, pay option arms, and most of all negative amortization. It is important to understand the difference as there are both opportunities you might want to take advantage of as well as risks you may be exposed to of which you may not be aware. So let's start the discussion with negative amortization.
Negative amortization occurs when you are not paying enough in your monthly payment to cover the interest on the loan or the principal. If you have a $300,000 loan with a 1% payment your payment is $964 a month. If you have an interest rate of 6% your total interest for the year will be $18,000 which is $1500 a month. That means the payment of $964 a month will be short $536 a month of the interest only payment.
The new balance on the loan will be $300,536. In one month you not only didn't pay down any amount on your principal balance, you added to it. Hence: negative amortization.
An additional penalty arises as you are now paying interest on interest. The $536 that was added to the balance is unpaid interest and the next month your calculation to determine the interest only payment is made on a balance of $300,536 thus you are paying interest on the (unpaid interest) additional balance of the loan. Each month this will increase under the scenario of a 1% loan with a 6% interest rate. Each month you will continue to pay interest on interest.
Which brings us to a discussion on Pay Option Arms. These loans became popular because borrowers had the opportunity to pay an unbelievable loan payment with the caveat that it may lead to negative amortization. As I have stated above, most borrowers didn't know exactly what that meant. Most mortgage brokers who specialize in these types of loans play down the negative amortization and play up the low payment. I believe that people do understand that if it seems "too good to be true", it generally is, but when times are getting tougher and making ends meet is getting more difficult, it is easier to be convinced that this type of loan is a great idea.
There are three other options which you can elect each month: an interest only loan, a 15 year loan and a 30 year loan. The problem with these is simple: the rates are too high.
If you wanted any of these loans, you can get a lower interest rate by simply taking that loan and forgetting about the pay option arm.
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