by Brian Brady
Commercial Real Estate Finance Expert
Structured Debt and Equity
Licensed Real Estate Broker in AL, CA, and FL
I wrote this article on Active Rain, about two months ago. It’s got legs in the comments’ thread over there. You’ll see that the REAL reason I’m worked up is that the “new sleazy option ARM advertisement” is to claim that you KNEW it was bad for the customer. The opposite is actually true
I’m pretty high-touch with my neg-am borrowers. I keep in close contact with them quarterly. I just received notice that one of them had a notice of default filed against them for non-payment. The borrower lost his job and elected to use the “side account” he established, from the monthly cash-flow savings, to rent a new home rather than to “feed the depreciating asset” (his words).
Before you comment on the article, you might read all of Dan Green’s “Mortgage Planning” articles. if you haven’t the time to read all of them, read:
If Low Downpayments Are More Risky To Banks, They Must Be More Safe For Home Buyers
I’d argue the same logic applies for negative-amortization (rising mortgage balances).
Here’s the article:
Remember the “sleazy Option ARM advertisements“?
They’re back but with a whole new twist:
This is why I never did option arms. This is part of the reason why we are in the housing mess we are in. Yes, borrowers have to claim responsibility, but every Bank that pushed neg am as a financing alternative deserves the billions in write downs and losses in stock options that they are mired in. I have no sympathy for them…only contempt!
Oh, brother! If I see one more loan hack Monday morning quarterbacking this mess I’m gonna puke. There is nothing wrong with negative amortization loans; there was something drastically wrong with the way they were prescribed. The “new neg-am” advertisements are “posited indignation” and they’re just as sleazy as the original advertisements. They prey upon the opposite of the greed motivation; fear. That ain’t helping anybody!
Let me try to break down the negative amortization loan for you:
- There is an interest rate charged; it may be adjustable monthly, annually, or for a specified period.
- There are payment options. One option is LESS than the interest assessed for the month. Borrowers have the “option” to pay the minimum amount or a higher payment.
- The difference between the lower amount paid and the higher amount assessed is added to the loan balance. The loan balance rises or amortizes “negatively”.
- If that balance rises to a pre-determined amount (usually 110% to 125% of the original balance), all bets are off; the loan becomes a fully-amortizing loan and the payment goes up…a lot.
Neither the neg-am loans nor the banks caused the housing mess; a supply and demand imbalance, combined with an adolescent nature towards understanding complicated loan products (by both borrowers and originators) did. I’m gonna help you out with this. Neg-am loans are neither good nor evil; they’re just financial instruments. When prescribed properly, they can be a super-charged problem solver or liquidity builder BUT…you gotta do your homework, first.
When does a negative amortization loan make sense for you?
How about when you’re looking to buy in a soon to recover market? NAR Chief Economist, Lawrence Yun believes that a V-shaped spike is due in three markets:
Middle-America cities that performed evenly over the past few years – like Cincinnati, Milwaukee and the Kansas City, Mo., area – are likely to experience home price gains in the 20 to 30 percent range over the next five years, while markets like Miami, Las Vegas and Phoenix could see prices go up as much as 50 percent during that time period, Yun said.
If you’re looking to buy a $300,000 home, with $150,000 down payment, in Las Vegas, you might consider buying a rental property in Phoenix, for $150,000, as well (geographically diversify). Spread the $150,000 over both homes and use a negative amortization loan to keep your payments affordable, for the recovery period. You might sell the Phoenix rental for $225,000, in 2013, and use the extra $50,000 to pay down the Vegas loan under $100,000, in 2013. That’s what wealthy people do. They buy low and sell high and the do it with other people’s money.
Maybe you’re saddled with debt and no lender is going to let you refinance with “cash-out”, you might need a negative amortization loan. Let’s assume you’re paying $2,200/month on your $300,000 fixed rate loan and $800/month in $40,000 in consumer debt (credit cards). In 3 years, your mortgage balance will drop to $290,000 and your credit card balance will drop to $27,000. If you took out a neg-am loan, with a $1,400 payment, and applied the $800 cash-flow savings to your credit cards, you’ll pay OFF your credit card debt in 3 years. You will have INCREASED your mortgage balance some $15,000 but you’ll be swapping 14% debt for 6.5% debt.
In the existing scenario, you’ll owe an aggregate of $317,000 in 2011. With the neg-am loan, you’ll owe an aggregate of $315,000 (on your mortgage) but your high-interest consumer debt will have been retired. Your credit score will most likely have risen, making your eligible for a MUCH better loan program. Oh, you’ll save a bunch of money on taxes, as well.
Finally, maybe you have no liquidity (we call that cash in the bank in financial planning circles). That’s VERY dangerous ! Investing that $800 monthly difference (if you have no consumer debt), can grow to a $35,000 nest-egg (assuming a 7% return). While the difference in mortgage balances will be $25,000 higher, with the neg-am loan, the investment account will have grown to $35,000; you’ll be ahead some $10,000 and have what we call in financial planning circles, liquidity.
Oh…by the way…liquidity=safety. When the dung hits the blades, cash in the bank is king !
Here’s the advice for today; don’t be swayed by the fear mongers of today; you weren’t swayed by the greed merchants of yesteryear. Do your homework, perform your due diligence, and call a mortgage adviser who has financial planning background. He’ll analyze ALL of your assets and liabilities, and tailor a loan solution specifically for your situation.
After all, aren’t you special enough to warrant personal attention?
Eric Bramlett says:
Brian –
I agree with you that neg-am ARMs aren’t inherently evil. But man…quoting Lawrence Yun isn’t going to win you many points with a lot of people. He’s been predicting an upswing since the downturn – it’s his job.
August 7, 2008 — 8:17 pm
Eric Bramlett says:
And btw, I’m not arguing for or against an upturn in the market – only that Yun is a “glass is half full” kind of guy to the extreme.
August 7, 2008 — 8:19 pm
Robert Kerr says:
Yes, generally speaking, liquidity is safety. But the devil’s in the details … liquidity funded with debt is not safety, it’s danger.
V-shaped? 50%? 5 years? Not a chance without a return to voodoo financing and, honestly, it’s deader than disco. Merrill just dumped $30B-plus of its ninja paper for 22c on the dollar.
Ridiculously optimistic forecasts in the face of very serious downward economic indicators is how Lereah lost all credibility before resigning in disgrace. Yun seems to be following Lereah’s playbook.
August 7, 2008 — 10:10 pm
chris e says:
I agree with you that financial products are neither good or evil.They are just instruments.
I’m faulting the institutions for both market crushes (90s and now) and here is why:
If a loan is underwritten at the teaser rate and not at the full going rate to qualify the borrower is setting him/her for failure.Then by relaxing their own lending practices and lending to practically anyone the institutions created a severe artificial demand that fueled prices.People were buying properties with nothing or 5% down, get a loan and expecting to make $100,000 in six months (see SO CAL).The banks have no reason to be careful in their lending practices as in the end the taxpayers are footing the tab for their mistakes.
Now there is no antidote known to men for greed.
You mentioning credit scores I wonder who was really was considering such things two years ago?
You can calculate all you want it won’t make any difference, (apparently it didn’t considering the market today).People want to make money and want to make money easy.The institutions provided the platform and now they are holding the bag.
No matter what a “financial planner” will advice there is no substitute for equity in a down market.If one does not understand that, has no business been in the market until he/she really learns it.No tailored loan will help
that person with out the full understanding what he/she is getting in to.
August 7, 2008 — 10:56 pm
Brian Brady says:
“No matter what a “financial planner” will advice there is no substitute for equity in a down market.If one does not understand that, has no business been in the market until he/she really learns it”
Equity disappears. Cash is king in a down market. There IS a difference, Chris.
August 8, 2008 — 7:03 am
David Shafer says:
Brian gotta disagree with you on this one. Sure there might be a few sophisticated folks who can use option arms to their advantage, but in my book that’s even arguable.
Here is what you didn’t point out:
1. Option arms are more expensive. There is a 1-1 1/2% surcharge on these loans because of the added risk the investor is taking on.
2. In order to hide that extra cost and to make these loans more desireable to the investor, a pre-payment penalty is placed on option arms (usually three years).
3. The increased foreclosure rate for option arms is a well known phenomenon, even before folks started pushing them to everybody
4. Some lenders allowed folks to qualify for these loans based on the minimum payment
5. 80% of folks make the minimum payment
6. The original option arms has a variable rate that changed every month. Adding this interest rate risk onto the other risks is crazy in my book even for a sophisticated person who understands this, but for the average consumer it was truly nuts.
Faced with these issues, a interest-only loan is a much better product for folks who want flexibility.
1. IO has a much lower interest rate than option arms
2. Has increased cash flow ability as well as the ability to pay down principal every month.
3. Comes in either fixed rate or variable rate products and doesn’t have teaser rates
Now, we all know that mortgages are just tools. But I really can’t find much if any use for the option arm tool. It defies basic finance to get into a situation where you increase the debt of a asset faster than the asset is appreciating. Since the underlying interest rates were in the 7-8% range, long term real estate appreciation is much lower than that. And if interest rates go higher, then it is an even dumber bet.
Now how these loans were advertised is another whole story. I mean people were told they were getting a (payment) rate of 1% or 2% and were not told what the actual interest rate was to closing. They had no understanding or were they told of the negative am part adding interest to the principal. So most of the customers (I assume you did a great job explaining it to yours) had no idea what they were getting. I know of some pretty sophisticated folks who told me they were getting a loan for 1-2%. I told them that was impossible and went into my spiel to no avail. They came to me later and wanted me to get them out of the loan at any cost, pre-payment penalty be dam$$$!
These option arm loans advertisements were in heavy rotation for several years on radio, TV and even bill boards in Florida. Not a single one of the advertisements had any kernel of truth in them other than the disclaimer at the end…….I simply refused to be involved in any product that was this questionable and this dishonestly presented to the public.
August 8, 2008 — 7:10 am
Brian Brady says:
“1. Option arms are more expensive. There is a 1-1 1/2% surcharge on these loans because of the added risk the investor is taking on.”
That’s…not true, Dave. Neg-am loans can be less expensive than I/Os. It all depends on the index/margin. The crap pushed by CFC and IndyMac was more expensive but I’ve tailored neg-am loans with very tight margins.
“2. In order to hide that extra cost and to make these loans more desirable to the investor, a pre-payment penalty is placed on option arms (usually three years).”
Again, for the crap products. Pre-payment penalties, however, are NOT, by their very nature, inherently evil. They can be an excellent trade-off for cost when executing a financial plan.
“3. The increased foreclosure rate for option arms is a well known phenomenon, even before folks started pushing them to everybody”
Which shouldn’t affect a SPECIFIC loan decision you or I might make to our clients.
“4. Some lenders allowed folks to qualify for these loans based on the minimum payment”
Again, that doesn’t affect a specific loan decision; you know if your clients can afford it.
“5. 80% of folks make the minimum payment”
Gosh, I hope so. I also hope they invest the difference.
“6. The original option arms has a variable rate that changed every month. Adding this interest rate risk onto the other risks is crazy in my book even for a sophisticated person who understands this, but for the average consumer it was truly nuts.”
It would appear so today. If the one month ARM outperforms a 30 year FRM, over a 5-7 year period of time, doesn’t that actually LOWER borrowing costs?
Here’s where I’m headed with this. All the arguments made AGAINST neg-am loans are because a bunch of morons sold them to bigger morons and the banks are trying to paint these as “bad” loans. The “new advertising” is posited indignation and that’s more evil than the morons selling them as “an easy out”.
The real problem is that mortgage originators think short-term while financial planners adopt a long-term approach. Until our industry can think beyond a 12 month (foresight and hindsight) horizon, we’re doomed as financial planning professionals.
I’m not picking on you, Dave…wait a minute, I guess I am picking on you, specifically Dave, because you understand this stuff well and are extremely consumer-centric. I think you’ll understand this statement:
I don’t care about the stats for the general populace; I care only about the instrument as it fits into a specific financial plan. A blanket condemnation of neg-am loans is like financial planners condemning listed options. Both instruments can be deployed in a VERY conservative manner.
It’s all about suitability and execution.
August 8, 2008 — 7:39 am
Brian Brady says:
Oh, Dave, your recommendation for IO vs. neg-am is perfect…TODAY. I couldn’t execute a low-cost neg-am loan that would outperform an IO, based on what I think will happen over the next 5-7 years…TODAY.
August 8, 2008 — 7:41 am
David Shafer says:
Brian,
Guess I never ran across a option arm that was less expensive than a I/O. What lenders offered these low expense option arms? The risk of option arms has always been higher than a conforming loan, so I can’t get my head around a product that is more risky but offered at premium pricing????
Its all about risk. If you have some clients that want to take on quite a bit of interest rate risk (both their mortgage and the real estate market) to gain a little cash flow presumedly to take on more risk (investment risk) then go for it. Me, I try to reduce some of that risk by suggesting I/Os.
And I have and sure you have had folks come to you talking about that 1% loan they saw/heard advertised. Do you sell them the product or try to talk some financial sense to them and move them to a more appropriate product even if that means you lose them as a customer? That is where I was going with the general population stats.
Finally, since I think long term (10 year minimum), and use long term appreciation/performance stats I still can’t see the benefit of increasing debt when the long term appreciation on real estate sits at 5% and the loans will have a much higher percentage rate than that over the long term. Its a reverse arbitrage situation and will always end up with a negative equity position over the long run. Now if you are flipping a property over the short run, then it might make sense.
August 8, 2008 — 8:28 am
Brian Brady says:
Good questions, Dave. I’m in “fighting with underwriters” land so I’ll have to beg off until this weekend.
August 8, 2008 — 10:20 am
Sean Purcell says:
Dave,
The risk of option arms has always been higher than a conforming loan, so I can’t get my head around a product that is more risky but offered at premium pricing
The original option arms (the ones being discussed here rather than the hybrid with the fixed rate that came out later) pass interest rate risk on to the borrower. This is considered very low risk for the lender.
Also, high costs, above market rates and pre-pay penalties are the result of greedy originators more often than not. Option arms were offered with extremely attrative margins and no pre-pay penalties as a matter of course. The originator is usually the one responsible for jacking up the margin and/or adding a pre-pay in order to increase their rebate. It got so bad that some lenders had to cap the rebate because originators could not help themselves from sucking the very marrow from their own clients. If you want to discuss poor loan advising from get-rick-quick loan officers that jumped into the business from their former career as music cd consultants at the local mall… that is an entirely different discussion.
If you have some clients that want to take on quite a bit of interest rate risk (both their mortgage and the real estate market) to gain a little cash flow presumedly to take on more risk (investment risk) then go for it.
With a few modifications this is almost exactly the recipe for long term financial wealth. The corrections: there is very little real estate market risk over any time period of consequence to financial planning. The market appreciates at an historically knowable rate with periods of accelerated movement in either direction. Like any investment, if you can buy near the bottom (even if it is not quite the bottom yet) it would be wise to purchase as much as possible. There is liquidity risk, meaning it is not as easy to get out of your position as a property owner as it would be to dump equities. Both of these corrections argue in favor of increasing liquid assets as an adjunct investment policy to go along with your real estate investments. Translated: create cash flow and protect liquidity to allow you to purchase more while the buying is good and also to protect you during a down market when you have transferred the risk to an institution. OPM (other people’s money) is the key to wealth accumulation.
One good tool for creating cash flow and/or protecting liquidity is the option arm; it does both.
My .02 worth.
August 9, 2008 — 9:59 am
Late Night Austin Real Estate Blog says:
The issue I have with neg-am is in context of the bailouts. Basically regardless of whether the banks properly disclosed the details of the loan to borrowers at this point the general public is holding the bag for the high rate of default. As long as we offer FDIC issurance to banks and are going to offer bailout programs when things go belly up I think there should be limits on loans that have a high rate of foreclosure.
Obviously some borrowers do well with neg-am and some mortgage brokers like Brian do a great job with disclosures. And if the mortgage field was only populated with people like Brian things would be different. But this isnt the case and probably never will be.
And in some sense the risks of these loan products are not only with the borrower and the bank. But some of the risk is being held by the general public. And as long as that is the case I think their should be a limit on some loans that have a high degree of foreclosure.
*That said I dont think we should look at limiting loan programs until things recover. Now is not the right time for additional govt restrictions. That time was 3 years ago or 3 years from now when hopefully things are much better.
August 10, 2008 — 3:29 pm