Negative Amortization: Risky Financing

Don't do it!

Negative amortization. Sounds like financial gobbletygook, but simply, it's a program offered by some lenders to tempt prospective buyers into buying more house than they might comfortably afford. When you've found the perfect house, but your finances don't quite match up for a perfect fit, you'll be confronted with a selection of different loan options from 40-year mortgages to ARMs. With so much complexity, it's not surprising that negative amortization can creep into the mix and take the innocent, the unsuspecting, and the uneducated home buyer unawares.

So what is it?

Negative amortization is exactly what it says.

When you take out a home loan, the payments and interest are amortized over a specific term. Conventional or fixed loans are set at a constant rate for the duration of the loan. In the beginning you pay a higher percentage in interest while only a small amount goes toward the principal. Over time, as the principal is paid down, the interest amount is reduced and the principal payment increases until the loan is finally paid off. The payment always stays the same. Other options include adjustable rate mortages (ARMs), mortgages with balloon payments, and interest only loans, for example.

With negative amortization, instead of paying down the principal incrementally every month, you are instead adding to it because the payment itself is not enough to cover the interest let alone any principal. The difference is tacked on to the principal amount. Typically, when the loan hits a particular threshold between 110 and 125% of the original principle, the loan is converted to a conventional loan at a much higher interest rate.

Instead of reducing the amount you owe on the principal it continues to grow, which is totally backwards from your probable goal of eventual ownership.

How does this happen?

With the housing market red hot in many areas now, competition is steep and home prices are climbing. This has fueled a feeding frenzy among buyers and the best market in decades for sellers. When you need to make instant decisions about purchasing, it's easy to see how a folks could get themselves in over their heads pretty quickly.

The fact is there is no more emotional decision than buying a home. It's the biggest investment most of us ever make and it embodies all of our hopes and dreams regardless of its price or appointments. As a result, many home buyers, especially the first time or young buyer, look only at the monthly payments to decide if they can afford a house. With a little "creative" financing, developers, real estate agents, and lenders combine to make your dreams a reality, but not necessarily with your best long term financial interests in mind.

Are negative amortizing loans ever okay?

If you are in a growth region where homes have been undervalued and now seem to be catching up with the market, you might be able to purchase a home for $300,000 and then pay on a negative amortizing loan short term, tacking a modest $300 on to the principal each month. If you are able to make a few cosmetic improvements, then resell the home after a year for $400,000, then subtracting the additional principal of $3600 and cost of improvements, real estate fees and so on, you might walk away with a modest profit. The negative amortizing loan would allow you to maintain your cash flow and over a short period would be offset by the home's appreciation in the current market. However, it could easily be a losing proposition if the market or your personal circumstances change. In other words, you need to be aware of and carefully weigh the risks.

Another possibility would be the case of a young professional who wants to purchase a particular type of home, but is not currently making the income to support the home desired. In a year or two they could become established in their careers and could see a substantial increase in income. Combined with a rapidly appreciating housing market, it would make some sense for someone like this to take the risk, especially if their financial prospects were particularly bright.

Negative amortization is also available as part of a few programs offered by some lenders to certain borrowers who are highly qualified that make it possible to pay less than the interest one month, interest only another, or interest and principal still other months. Such borrowing, though possible, is not the norm, because this type of borrower typically has significant assets already.

The big downside

Negative amortization or other "creative financing" can make it possible for you to move into the home of your dreams, but without carefully assessing the risks, those dreams could come crashing down around you. In an overheated market, the best advice is to be cautious, get prequalified by your lender in advance, and lower your sights to include homes that you can afford if circumstances change such as divorce, job loss, or extended illness.

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