Interest only is not a pay option arm

Roger Schlesinger
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Posted: Dec 14, 2006 11:42 AM

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.

How do you determine the actual interest rate on one of these loans? First of all these are straight variable loans which can have a new interest rate every month. The payment rate (1%) stays the same all year and then only goes up a little each year for the first five years. Remember THIS IS A PAYMENT RATE NOT AN INTEREST RATE!

All of these pay option loans, as you will find in all adjustable loans, have an index and a margin. The index is either the average yearly t-bill or a libor index ( one month, six months or one year.) Those are the two most popular indexes although there are several others. Every month that the index moves the interest rate moves. How much the rate moves is dependent on the margin.

The margin is a figure that you are assigned when you take the loan. An amazing margin is under 1% while a poor one is over 3% Although it is the borrowers decision on what index and what margin they choose, most do not know either term and never seem to have or even want a part in what determines their interest rate. This has to stop if the borrowers in this country want to improve their financial position. Just because you are told this is the best loan for you doesn't mean that it is. Investigate it. Learn before you're burned.

And now we will discuss Interest Only loans which are, in my opinion, good loans that have been tarnished by the negatively amortizing pay option arms. Interest only is really an option not a loan. Just because it says interest only for five or ten years doesn't mean you have to ever pay even one month as interest only (just the interest, none of the principal). You cannot ever go negative on a interest only loan because you must pay the interest due each and every month!

There are several things I like about the interest only loans. The first is that as a self employed or commission sales person you can keep your payments low for the majority of the time, and then, when you get a good check, you can pay down on the principal. Once that happens your interest only payment is lowered because the principal of the loan is lower. This works for bonuses as well obviously. The other point is that if you run into a bad period, you can pay interest only until things turn around. That is a worthwhile option to have in your back pocket!

The mortgage industry is getting more complex as new products are introduced to the market. For the vast majority of American borrowers, this is your biggest liability. Take time to learn about the industry and do more for yourself than just calling different companies and asking about their rates. Learn the ins and outs of the products so you can find what works for you. As always, I am just an email away.