Bruce asks....Ron...can you give us the straight scoop on 1% mortgage that so many mortgage companies are advertising?
Certainly, Bruce... It's true. Mortgage bankers and brokers have been advertising the 1% mortgage as if it was a gift from above. Its also called an Option ARM, Pick-a-Payment, FlexPay, MTA...among others. It happens to be an interesting loan because with each monthly statement you are given the option of any one of 4 different payments...you can pay just the monthly interest, you may choose between a 15 year or a 30 year amortizing payment and you are given a 4th option, a payment that is less than the interest only payment. If you choose this option, you create deferred interest...also called negative amortization.
Isn't negative amortization bad?
It completely depends on the situation. Fact is, negative amortization can be a useful tool - if it's used properly. It presents an opportunity to defer part of your payment to some time in the future. The problem is that some people will "access" the negative amortization without regard to paying it back. And at some point, it will need to be paid back. Not only will the deferred interest need to be paid, but interest is charged on the deferred interest. Interest on interest, so to speak.
When a borrower relies on the lowest payment option just to keep up, well, that's just bad financial planning. Good financial planning would be if you used the lower monthly payment in order to pay off other debts - especially if those other debts carry higher interest rates and are non tax-deductible. Here's my rule of thumb. If you can only handle making an interest only or negative amortization payment, then stay away from the loan. If you are using it as part of a total financial planning effort, then the loan may make some sense. But please, do not let some rookie loan officer talk you into taking the loan because home values are appreciating or because you can refinance you in a year or two. That loan officer is only looking out for themselves... not you.
At 1%, the payment should be super low, right?
Well yes, it is. But you must understand that 1% is the interest rate only for the first month. After that, the 1% is actually a payment rate - not the actual interest rate.
What's the difference?
Here's how it works. The loan offers a payment for the first year of the loan amount at 1% amortized over over 30 years. That becomes the minimum monthly payment for the 1st year. But after the 1st month, the actual interest rate jumps up - to a rate that is the sum of an index (1 year treasury bill, LIBOR, 12 months average of the 1 year treasury bill, etc), PLUS, a margin. I'm sure everyone realizes that a 1% fixed rate mortgage doesn't exist. And they would be correct. So advertising a 1% rate is definitely misleading. You're allowed to make the 1% rate payment, but that payment will be much less than the payment required to cover your principle & interest. This is how negative amortization occurs.
So why are we seeing so many advertisements for this 1% mortgage?
There are a couple of reasons. I may invoke some anger and criticism from mortgage brokers and bankers but here's the truth of the matter. The Option ARM is an easy sell. It provides for a super low payment for the amount being borrowed. It pays brokers and bankers very well - since some risk is transferred to the borrower, the lender has an extra level of protection when interest rates rise. So these loans can be more profitable versus a fixed rate and lenders can compensate bankers and brokers for this transfer of risk.
Also, as stated earlier, these loans come with a margin. A margin is the amount added to an index which is then used to compute the borrowers future interest rates. Most borrowers know nothing of margins and brokers receive compensation based on the margin - the higher the margin, the higher the compensation. Do you see how a loan officer might feel free to make as much as he can on a mortgage? Sure it does. Also, it's new. And people love new things. So the loan officer has a product with a bunch of bells and whistles, that's easy to sell because of the low "payment rate", they can make a lot of money on the loan and most borrowers don't know enough about the loan to shop it. That being said, the loan does allow you to purchase more home for the money.
How?
First, lenders will usually offer their adjustable at rates that are lower rate than their fixed rates. You're accepting the risk of rising interest rates. Why would you take an adjustable if you're not getting something in return? Secondly, you may pay just the interest on the loan...no principle. Those two features make for a pretty low payment. To give you an idea.....say you borrow $300,000 at 6.5% over 30 years...the regular amortizing payment is $1896.20. An interest only payment at 6% is only $1,500.. With housing prices being what they are, you can see why these types of loan are popular.
