Have you decided on a new home that you're going to make an offer on? Or maybe you are planning on refinancing an existing mortgage, and are deciding what you want your monthly mortgage payment to be. Choosing how much to pay each month is a good place to start. It's one of the first questions a car salesman will ask when you walk on to his lot, and with all the new types of mortgages, it's now a question that can be asked by many mortgage lenders.

Innovative mortgage products, sometimes called exotic mortgages, have features that allow borrowers to minimize their monthly payments early in the life of the mortgage in exchange for higher payments down the road. Most borrowers believe they will refinance their mortgage or move before those higher payments set in. However, a misunderstanding of the risks associated with these mortgages can lead to financial stress - or even disaster. (To read more about shopping for a house, see Understanding the Mortgage Payment Structure, Shopping For A Mortgage and Make A Risk-Based Mortgage Decision.)

In this article, we'll discuss the mechanics of mortgages with low initial payments and the uses and risks associated with these mortgages.

How Much?
So, what do you want your monthly payment to be?

To help you decide, let's take a look at four common categories of these loans: fixed-rate interest-only loans, adjustable-rate interest-only loans, fixed-rate graduated payment loans and payment option ARMs. Figure 1 charts the outcomes for each of these payment options on a $400,000 mortgage over 30 years. The interest-only mortgage has a 6.5% fixed interest rate over the 30-year term; the 5-6 interest only ARM has a 6.125% 5-6 interest rate; the fixed-rate graduated payment mortgage has a fixed 6.5% rate and there is a 2% teaser rate on the payment option ARM.

Copyright © 2007 Investopedia.com
Figure 1

Interest-only Mortgages
Interest-only mortgages allow the borrower to pay only the interest charge on the outstanding principal balance of the mortgage. This is a simple calculation made by dividing the interest rate by 12 (months) and multiplying that number by the principal balance of the mortgage. When an interest-only payment is made, there is no amortization of the mortgage (the principal balance of the loan is not reduced).

Interest-only mortgages are available in both fixed-rate and adjustable-rate loans (ARMs). A 30-year fixed-rate mortgage will usually have a 10-year interest-only period after which the monthly payment amount is recalculated so that the mortgage will fully amortize over the remaining term of the mortgage.

Monthly adjusting and 5-6 ARMs are popular interest-only adjustable-rate mortgages. Monthly adjusting ARMs usually have a 10-year interest-only period after which the monthly payment amount is recalculated such that the mortgage will fully amortize over the remaining term. 5-6 ARMs have an interest-only period that lasts for the five-year fixed-rate period only. After the five-year fixed-rate period, not only will the interest rate start to adjust according to an index plus a margin (the fully indexed interest rate), but the monthly payment must be recalculated so that the mortgage will fully amortize over the remaining term. 5-6 ARMs are called 5-6 because the interest rate adjusts every six months on a 5-6 ARM as opposed to every 12 months (annually) as seen in a 5-1 ARM. (To read more about ARMs, see Mortgages: Fixed-Rate Versus Adjustable-Rate, ARMed And Dangerous and American Dream Or Mortgage Nightmare?)

Negative Amortization Mortgages
Negative amortization mortgages take the reduction of the required monthly payment one step further than an interest-only mortgage. Negative amortization mortgages allow borrowers to make a payment that is less than the interest-only payment. When that payment is made, deferred interest is created. The amount of deferred interest that is created each month is then added to the principal balance of the mortgage - hence the name negative amortization.

Figure 2 illustrates how a negative amortization mortgage works. Notice how the principal balance increases each month by the amount of the deferred interest - with the exception of month one.

Copyright © 2007 Investopedia.com
Figure 2

Negative amortization mortgages also come in both fixed-rate and adjustable-rate mortgages.

Fixed-Rate Or Graduated Payment Mortgages
Fixed-rate negative amortization mortgages are generally called graduated payment mortgages. The interest rate for a graduated payment mortgage is fixed over the life of the loan, but the loan has a schedule of initial payments that start at an amount that is less than an interest-only payment (negative amortization is created) and increase until the payment becomes large enough to fully amortize the loan over its remaining term. See Figure 3 below.

Copyright © 2007 Investopedia.com
Figure 3

Adjustable-Rate Or Payment Option Mortgages
Adjustable-rate negative amortization mortgages are generally called payment option ARMs. A payment option ARM is the most complex of popular mortgage products. For a payment option ARM, an initial "minimum payment" is calculated based on a temporary start interest rate. This temporary start rate lasts from one to three months. During this temporary start rate period, the monthly payment made by the borrower is a fully amortizing payment.

After the expiration of the temporary start rate, the borrower still has the option to make a payment equal to the payment that was calculated based on the initial start interest rate (the minimum payment), but the actual interest rate on the mortgage becomes the fully indexed interest rate. There is a high probability that the minimum payment will be less than the interest-only payment. Therefore, deferred interest is created and added to the principal balance of the mortgage.

The rate of change of the fully indexed interest rate will determine the rate at which deferred interest is added to the principal balance. (The rate at which negative amortization is created.) If that were not complex enough, typically there is a provision in the mortgage contract that states the minimum payment will increase by 7% or 7.5% annually. And, at the end of five years the mortgage will "recast".

When the mortgage recasts, its monthly payments are recalculated so that the mortgage will be paid off by the end of the remaining term. The new monthly payment is based on the fully indexed interest rate at the time the mortgage recasts. This payment becomes the new minimum payment, and the cycle starts all over again.

Note: Payment option ARMs have a "negative amortization limit" that states that if the outstanding principal balance of the mortgage reaches a certain percentage of the mortgage's original principal balance (usually 110-125%), an "unscheduled recast" will be triggered.

The Benefits and Risks
There are many reasons why interest-only and negative amortization mortgages are introduced to consumers by mortgage lenders and financial planners; they all carry risk, but these mortgages can benefit some borrowers:

Benefits

  • In high cost areas, interest-only and negative amortization are popular. They provide a way for a borrower to afford a nicer home (subject to underwriting standards).
  • Interest-only and negative amortization mortgages might be an option for someone who will have an increase in income in future years.
  • Interest-only and negative amortization mortgages might be suitable for someone who has irregular income, such as an annual bonus that makes up a large percentage of his or her income.
  • Some financial planners advise borrowers to minimize their mortgage payments early in life and invest the difference between an interest-only or negative amortization mortgage payment and a fully amortizing mortgage payment.

Risks

  • Most borrowers of interest-only and negative amortization mortgages are counting on rates of home price appreciation to make irrelevant the fact that they are not paying down, or increasing the principal balance, of their mortgages. Making unrealistic assumptions about the future rate of home price appreciation is very risky.
  • Adjustable-rate interest-only and negative amortization mortgages are subject to a great deal of payment shock risk. In other words, the monthly payments will increase by design, and could increase by unanticipated amounts or at unanticipated times.
  • Minimizing a monthly mortgage payment to make investments creates risks. In general, interest-only and negative amortization mortgages are designed as five-year products. Five years is much too short of a time horizon to assume a stable rate of return in the stock market. In other words, at the time the mortgage is planned to be refinanced five years down the road, the stock market is too volatile to say that a sufficient return will have been earned over those five years to cover the interest charge on the mortgage.

Conclusion
It's not all about the initial monthly payment of interest-only and negative amortization mortgages. Consumers need to understand the mechanics of, and identify and measure the risks associated with, interest-only and negative amortization mortgages. Only then can a consumer make a well-informed, educated choice about a choosing a mortgage.

To learn more about alternative mortgages, or for a one-stop shop on subprime mortgages and the subprime meltdown, check out our Subprime Mortgages Feature.

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