Negative amortization?

[investinAK]

I have been seeing lots of TV commercials advertising for "negative amortization" mortgages. What are the purpose of these?

Thanks for your clarification!

Ryan

[Dan Auito]

Very low payments will allow you to rent things out for positive cashflow while you wait for appreciation to kick in and build the value faster then the debt mounts. When you are in strong markets with healthy appreciation rates it's just another way to play the game. The person who knows what they are doing and can accurately forecast and capitalize on their particular markets events and reasonably expected returns will sometimes take advantage of a program like this to maximize immediate returns.

[mcole]

If I may add to Dan’s excellent response, which I think pretty much says it all in the first sentence -- Cash-flow.

Many of these loans are a “pay-option” type of program, where each month the borrower has the choice of what they pay. Typically, they can make a minimum payment (below the interest rate), an interest only payment, a payment based on 15-year amortization, or a payment based on 30-year amortization.

This can sometimes be beneficial for a person whose monthly income fluctuates, or they hit a rough spot in their income. But it can also be dangerous if they don’t know how to manage their finances. Or, they don’t know their market, as Dan points out.

For the investor, it can be a great cash-flow tool for holding property short term, i.e. Lease/Option, Contract for Deed, etc., where you have a predetermined exit strategy and set price.

In this case the key is in fixing the future value of the property, knowing the maximum in potential deferred interest (negative amortization), and making sure you have no prepayment penalty, or at least a soft-prepay.

In the right scenario, this type of loan can definitely turn a so-so property into excellent cash-flow (for a year or two).

HTH
Mike
:SM005:

[Tom Henderson]

Negative amortization can be very dangerous because rather than reduce principal on each payment, or even keep the principal constant, as in an interest only loan, a negative amortized loan actually increases the principal.

While it is touted as a way to increase cash flow, unless there is strong appreciation, you are not going to like the outcome.

From a practical standpoint, if you have to resort to a negative amortization to make a property cashflow, you might consider passing on that property. I know I would. Think about it...is it really a good deal if you have to get a loan with less than interest only to cash flow? This is a foreclosure in embryo.

BTW.."negative amortization" is sort of a contradiction in terms. Amortization comes from the French, meaning to kill. Hence names like mortician, mortuary etc. Mortgage comes from the same root. Amortize literally means "to kill off" the loan. If you are increasing the loan, you cannot be "killing it off".

My advice is to pass on loans that increase principle. Why even consider deals with negative amortization, when you can work on deals where there is zero interest.

Hope this helps.

Tom Henderson
H&P Capital Investments LLC
214.575.8292
1.800.481.6588
tom@hpnotes.com

[LeadingEdge]

This is great and very informative for a teaching tool.

guys Thanks and if you could show an example of how one would be structured to be a good way to do a financing deal scenario and then debate it like now so the visualization can be doen for the newbies like me????????

Thank you so much for this thread. :praise: :praise:

[Jim Johnson]

My two cents... If you are flipping a property, and there is LOTS of equity and you are going to sell it in short order... these loans make huge amounts of sense. If you are investing, for a return over time... buy on fixed rate financing even if you must pay more for the loan. When I run an APOD on any property, I never place appreciation into the equation. The property might have additional cash flow through inflation, and your return in the end might be improved through appreciation… but if you figure those things in your gambling. OK… over time you know you will have both of these things run true... but do not really count on them. If after several years, or a zoning or economic change of some sort you think your equity to return is too high, evaluate your appreciation then. I might not make as much money as I could investing in real property, but I have not yet lost money. By the way, in the mobile home parks I look at a 10-15% cash on cash return, at 10-15% down is a good start. I look for improvements to increase that return to at least 25% in the first 24 months or I will not do the deal. And mobile home parks do not usually get fixed financing, but there are ways to get it. Dig in and be safe!

I have been seeing lots of TV commercials advertising for "negative amortization" mortgages. What are the purpose of these?

Thanks for your clarification!

Ryan

[investinAK]

To be honest, I had never really thought about using these loans in investing, I thought they were geared more toward consumers in bad times. It sounds to me, based on the posts here, that these loans might be more or less geared towards "speculators" rather than investors...I guess they may also make sense for very short term loans as well, as you all said.

Thank you all for your posts!

-Ryan

[Frank J. Festa, Jr.]

May I add the following:

Negative Amortization, An increase in the outstanding balance of a loan caused by the failure of the mortgage payments to cover interest charged on a loan.

Also, when an ARM has a payment cap that results in monthly payments that are not high enough to cover the interest due.

You can find this in a Shared Appreciation Mortgage (SAM). When the borrower agrees to share the property's appreciation with the lender.

Frank

[wilcox59]

It depends on what you do with the difference between the 30 year payment and the minimum payment. If you are going to buy a new car, boat or other toy since you have a lower payment on your home neg am loans are not for you.

If on the other hand you are disciplined enough to invest the difference and the home continues to appreciate it could be a good thing.

[mcole]

As I indicated above, I believe if you have the right deal and have your exist plan in place, you don’t have to rely on appreciation to make this type of loan work. In fact, I would never rely on appreciation.

But to give a real life example, I recently put together a loan for an investor who was buying a property, and had a tenant/buyer ready to go with a signed contract (one-year option). The 1st we used was a pay-option ARM, with a 2% start rate.

They didn’t need this kind of a loan to make their deal work. But in this particular case, it meant they could easily increase their positive cash-flow by at least $200 per month. Granted, any deferred interest gets added back to the principal. But the investor allowed for that when calculating their net return.

And as I recall, they're making around $25,000 on the deal, but will end up deferring about $1,500 in interest. Which simply means, they will receive $23,500 when their buyers close. And which is also about the same as they would effectively net if they were making interest-only payments.

The interest is going to get paid one way or another. They just chose to do it at the end, out of the money their buyer’s will bring to the table. So in a sense, all they’re really doing is tapping into their future profits now and receiving some of it on a monthly basis, rather than waiting.

Again, I believe these types of loans can work for the right scenario and if used short-term. But they can definitely come back to bite you long-term, or if used for the wrong reasons.

Just my 1 cent worth
(I deferred the other one)
:)