Example:

I had to explain to a client’s CPA why the APR was lower than the start rate when the numbers confirmed it couldn’t be true. First, I had to figure it out, and it wasn’t easy!

The loan was a 3 year ARM, interest only, amortized over 30 years.
The first 36 months: the payment was $1600 a month.
The next 84 months: the payment was $1400 a month.
The last 240 months: the payment was $2200 a month.
The first 3 years: the rate was 6.5%, the APR 5.375%

Just looking at the figures, how could this be?

The answer is simple if you understand how the APR is calculated and how ARMs work. The interest rate after the fixed period is equal to the index (1 month LIBOR) and the margin (short for profit margin 2.25%) This added up to 4.875%. The loan was interest-only for 10 years, so the first 84 months of the variable portion of the loan must be projected at interest-only.

That gets us to the last 20 years of the loan, which is no longer interest-only. The loan must be totally paid back at the end of 30 years, so it must be amortized over 20 years, thus the higher payment but not necessarily a higher interest rate to catch up on the pay-down of principal. Most people, and some of them being in the mortgage industry, wouldn’t grasp this and shouldn’t need to learn this.

Stop the deceptive advertising and most of the problem would be gone. When the 1% option ARM was popular, I never heard anyone say or write that the 1% was the payment rate, not the interest rate. They would always say “1% interest” which technically was true for the first month in a 360 or 480 month loan. The next 359 months or 479 months were at a dramatically higher interest rate and thus because your 1% didn’t even cover the interest in almost every case you would experience negative amortization. That means your balance would be going up, not down. How did the lenders cover that problem? One line! “Your loan has the possibility of negative amortization!” They simply forgot to mention that the possibility was 100%. (If only I could get such odds in Vegas.)

The lenders weren’t through with enticing you to take this loan, and they’re still at it. You have four ways to pay your loan: the teaser rate that will put you into negative amortization because as I have said before it is less than the interest you owe for the month, interest-only, 15-year amortization, or 30-year amortization. Unfortunately the interest rate, determined by the index and the margin, makes the interest-only loan, the 15 year and the 30 year more expensive than just going into the market and taking one of those loans. By the way, do you realize that if you take an interest-only loan, which in reality is simply an option, you can pay that loan either interest-only, or as a 10-year, 15-year, 20-year, 22.5-year, 30-year, or any other amortization you choose? As long as you are paying at least the interest-only, you can add any amortization you want to the loan and pay it your way. Seems a whole lot better than the negative amortization option!

I could go on for much longer but I believe it would be redundant. Let common sense prevail and when you need to regulate, do the most good. Stripping home values with the stroke of a pen—bad. Improving understanding of mortgages—good. It is a simple concept, but not easy to grasp!