The worse the loan, the easier to entice

Posted: Feb 12, 2007 9:46 AM
The worse the loan, the easier to entice

Although the headline seems ridiculous, it has never been more on point than in the current mortgage market. I have said to anyone who will listen that the 1% loan cannot have any traction left to it, but my amazement keeps growing as fast as the demand for this loan.

There is even a nationally advertised attorney who is threatening a class action suit against lenders who "push" this loan, and the lenders still keep coming up with new angles. At some point, you would thinkg that either I would learn something or the borrowers would learn something, and yet it seems neither of us can get a grip on this phenomena.

First and foremost, this is not a new loan. It has been around for at least several decades.

It has gained popularity as many mortgage advertisers tell you such things as "it's the biggest no brainer in the world" or "just because the mortgage payment doesn't go toward your principal, it doesn't mean your house won't appreciate". Huh! Can anyone say non- sequitor? Wouldn't you think someone might regulate the advertising we are forced to endure. Maybe we could have a group of M.D.'s report that children that are not yet in high school could revert toward childhood if subjected to this drivel.

What am I talking about you ask? I'm speaking of the option arm. Most people would refer to it as the 1% interest rate loan, but that wouldn't be correct. It is the 1% payment rate loan, and that is where the problem arises. If you watch old movies, or the Sopranos, you realize that when you borrowed money in the past, you had to make your payments, generally interest, on time or face some physical hardships. Well, that concept is the antithesis of that loan. Not only do you not have to make any principal payments, you don't even have to make most of the interest payments either. HOW SWEET IS THAT! If 1% is too high, we now have a payment of $20 per $100,000 or $200 per $1million. If the 1% loan is a "no brainer", I can't even begin to guess what this one will be called.

Let's take a good look at this loan. From my introduction, you probably think that the 1% payment is the worse thing about the loan, but you would be wrong. It is called an option arm because you have three other options that you can pay: interest only, 15 year fixed payment or a 30 year fixed payment. The problem is if you wanted to take an interest only loan or a 15 or 30 year loan, you could most likely get these loans at 1/2% or more lower than what you are being offered. So let's recap: you get this loan with this wonderfully low payment, and if you are worried that it could lead to some danger, you have three options that are much higher than a straight retail loan. And you think that my industry, the mortgage industry, can't do clever marketing? They make some of the legends of the past, P.T. Barnum, Mad Man Muntz (I lose money on every deal but make it up in volume), the inventor of the pet rock and anyone of your local hucksters that might have been around when you were growing up look like rank amateurs.

Now lets examine the 1% or the $20 per $100,000 feature of this loan. On a $200,000 loan at 1%, your payment is $643 per month amortized over 30 years. Otherwise, you could take the other new one and your payment would be $40 per month. The interest on the loan at 7.5% would be $1250 a month. In the 1% example, you would be "going negative" by $607 a month and in the $40 example your negative would be $1210 a month. Your annual negative would be between $7700+ and $14,500. These amounts are added to your balance and will also carry interest, so you get to payback the principal and the interest and the interest on the interest.

Writers note: On the $20 per $100,000 loan, you must have 35% equity in your house or you can't get the loan. In the above example, it would mean having a value of $307,000.

You would need that much because this loan would probably be suspended when your balance would reach 120% of the original loan ($240,000) which would be in about 3 years.

At that point, you would have to make at least full interest payments which would be about $1500 a month. This is a variable loan so all the figures are based on the current interest rate. If the rates drop or increase, there could be significantly different results.

Why does this loan exist? First and foremost, it exists because it can be sold with ease regardless of what anyone might say. Is there any good use for this loan? Absolutely! But its use is good for a very few people. In the four examples I am going to give you, I have only ever used it in the first example.

1. Huge equity and little income.

2. Need to use your money all year but still wish to have maximum write off.

3. Alternative to a reverse mortgage and generally cheaper.

4. Owning a spec house that hasn't sold and needing a lower payment.

I have put out four or five of these loans to clients who have several million dollars worth of equity and have loans of a half million to about three quarters of a million and basically haven't any current income. The fact that the loan could go negative $100,000 in a couple of years was insignificant to them. All of these loans were retired within three years through the sale of the property or the refinance of the loan to a non negative situation. Note: In the early 2000's, the payment was around 3% and the actual interest rate was 2% or under giving them positive amortization for several years. Once interest rates started climbing, they moved to other loans.

The second reason is the best one as you can use most of your money all year long and on December 30th, make up the negative with a payment to the bank; you then get the entire write off as if you had been making the same payment all year long.

Number three I have just started suggesting as reverse mortgages are quite expensive and limiting in scope. I suggest taking out enough money to cover five to ten years of need and setting aside enough to make the payments at the low rate. Your equity will shrink unless the house continues up in value, but that is what happens in a reverse mortgage.

The fourth reason is a desperate move, but desperate times require these types of moves. It goes back to planning for all contingencies when you set out to do something of this nature.

One simple point before I conclude: The mortgage industry has some marvelous loans and the 1% one shouldn't color your view of the industry. Just consider it the Edsel of our industry and hope that it fares as well as the Edsel did as the basis for future models that were definitely more successful.