Can I ease out of my pay-option loan?

by Morgan Brown

Mortgage Banker

Author website

Heard this one before? I tell you what, if I had a nickel… skip it, you know what I’m saying. During the last few years home owners, especially in areas with exceptionally low levels of housing affordability, have flocked in droves to the “dreaded” pay option mortgage. Now with recasts looming, interest rates rising, and equity dripping away, more and more home owners are calling me asking how they can still afford their home AND stop losing equity.

A quick thought on the “dreaded” pay-option mortgage. Negative amortization gets a bad rap these days. The mainstream media loves these loans because they are the ideal poster-child of a mortgage market debacle. Think about these loans for a minute: they eat home equity, have high interest rates (usually), are confusing, and make the people who sell them A BOAT LOAD of money. That sounds like music to a reporter’s ears. And so they get a bad rap.

While I generally dislike pay option loans, it’s not the loans themselves; it’s how they are (mis)used. To be sure, neg-am pay-option loans have a place in the lending spectrum; but I believe that place to be with the short-term, savvy investor, playing the flipping game in a rising market, not with the family of four trying to buy a bigger house in San Francisco while working with restrictive cash flows. The problem is that the people calling me are not the savvy investors; it’s the family of four that took a neg-am loan, got addicted to the minimum payment option, and now is in a world of hurt.

These people chose the pay option for either the low payments, the low fees (with a commission north of 3 points on the back of these loans, anyone charging front points with a full margin is sadistic), or they liked the idea of choosing their payment option each month. Most people in the payment-option loans made two critical mistakes: 1. they took the loan for a property they planned on staying in for a long time and 2. they lacked the will power to make anything more than the minimum (neg-am) payment. These are fatal mistakes when using this loan.

Now our family of four is either facing a recast, where they have maxed-out the neg-am portion of the loan and are looking at a huge monthly payment jump or they are watching their interest rate change each month up and up and up. So they want to get out. They want stability; they don’t want to lose any more equity. They want a 30 year fixed loan. They blanch when the payment I quote them is quadruple their minimum payment now. They freak out! What else can they do?

This is where we, as mortgage professionals need to come in and start looking at their options realistically. We need to asses the following: how long they plan on living in their home, what their current and future income situation looks like, what their current and future expense situation looks like, and what social/familial/other obligations/expectations are impinging on them at the moment. When we have all of those pieces of the puzzle we can look at some realistic options.

If we think they have a shot at staying in the house -and that is what we’re going to assume here- the easiest step is to look at an interest only loan. Assuming that they have equity in their home remaining at the time of their decision to get out of the pay-option, this is a no-brainer. While it doesn’t help them improve their equity situation, it can stabilize them and keep them in the house that they love and cherish while giving them some payment relief. Granted, the interest only payment is more-than-likely double their minimum payment, but a 10 year interest only loan with a 30 year term is the first option to look at for this family. (Please hold the “What if they can’t afford their payment doubling?” and similar questions for now, thanks.)

The next option to look at is some other type of payment-relief product such as a 40-year term mortgage. This may be beneficial for customers who can’t qualify for interest only payments. They can keep the payments lower than a traditional 30 year term which may provide similar relief as the interest only loan.

Another option to look at is another negative amortization loan. By using another negative amortization loan with a higher start rate (e.g. 4% vs. 1%) you can ease them back into a full payment mortgage while still providing them payment relief and minimizing the loss of equity.

The last option I want to look at is a temporary buy-down loan. While these were popular back in the day, the recent low interest rate environment has made them virtually non-existent. By using a temporary buy-down on a traditional 30-year fixed loan you give the borrower time to ease back in to a fully amortized payment. A 2-1 buy-down can give the borrower the stability of a fixed mortgage while giving their incomes time to increase or their expenses time to come down to earth to help them afford their house payments.

Out of the four options I like the interest only and temporary buy-down options the best. They provide the best opportunity for stability while reducing the payment shock associated with getting off of the neg-am minimum payment fix. I think the worst option is to go back in to another neg-am. I only mention it because it is an option.

Sometimes, though, after maxing out the neg-am portion of a pay-option loan there isn’t much that can be done in terms of refinancing. Especially with the recent changes to underwriting guidelines, high loan to value (LTV) loans are more difficult to finance. A homeowner who is near 95% on their LTV may not qualify for an interest only loan. They might not qualify for any financing. At that point, as an originator, its time to start talking about hard options; and that discussion has to include selling the home.

It is OK as a loan originator to recommend to a customer to get out of the house. More of us need to do it. We can see the writing on the wall better than our customers can. We are not attached emotionally, we have more experience in these situations, and we owe it to the customer to give them an honest opinion on their chances of successfully affording the home in the near future. Regardless if we earn any money out of the transaction, it behooves us to provide sound advice based on an honest assessment of the customer’s situation. If they can’t afford the home, the best thing they can do is sell and go find something they can afford.

If the customer chooses to listen to you (and that is a HUGE if, no one likes to be told they can’t afford what they bought) they will thank you for saving them from certain doom, and will probably use you for the smaller home they purchase down the street.

So, can you ease some one out of a pay-option loan? Sure you can. The financing options are there. Will it require a change in their lifestyle? Absolutely. Will it require skill, planning and guts on your part? Guaranteed, especially if you have to tell them to sell. You might as well get used to it — there are a raft of neg-am loans set to recast just on the horizon. If you can navigate your client successfully out of their neg-am loan while helping them maintain their financial solvency you’ve gone a long way towards earning a client for life.