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September 15, 1998
Negative
Amortization and Related Concepts
Ordinarily, the mortgage payment you make to the lender has two parts: interest due the lender for the
month, and amortization of principal. Amortization means reduction
in the loan balance -- the amount you still owe the lender.
For example, the monthly mortgage
payment on a level payment 30-year fixed-rate loan of $100,000 at 6% is
$600. In the first month, the interest due the lender is $500, which
leaves $100 for amortization. The balance at the end of month one would be
$99,900.
Because a payment of $600 a month
maintained over 30 years would just pay off the balance, assuming no
change in the interest rate, it is said to be the fully amortizing
payment. A payment less than $600 would leave a balance at the
end of 30 years. A payment greater than $600 would pay off the loan before
30 years.
Suppose you made a payment of
$550, for example. Then only $50 would be available to reduce the balance.
Amortization would still occur, but it would be smaller and not sufficient
to reduce the balance to zero over the term of the loan. $550 is a partially
amortizing payment.
Next, suppose you pay only $500.
Since this just covers the interest, there would be no amortization, and
the balance would remain at $100,000. The monthly payment is interest-only.
Back in the 1920s, interest-only loans usually ran for the term of the
loan, so that the borrower owed as much at the end of the term as at the
beginning. Unless the house was sold during the period, the borrower would
have to refinance the loan at term.
Today, some loans are
interest-only for a period of years at the beginning, but then the payment
is raised to the fully-amortizing level. For example, if the loan referred
to above was interest-only for the first 5 years, at the end of that
period the payment would be raised to $644. This is the fully-amortizing
payment when there are only 25 years left to go.
Finally, suppose that for some
reason, your mortgage payment in the first month was only $400. Then there
would be a shortfall in the interest payment, which would be added
to the loan balance. At the end of month one you would owe $100,100. In
effect, the lender has made an additional loan of $100, which is added to
the amount you already owe. When the payment does not cover the interest,
the resulting increase in the loan balance is negative amortization.
Purposes
of Negative Amortization
Historically, the major purpose of
negative amortization has been to reduce the mortgage payment at the
beginning of the loan contract. It has been used for this purpose on both
fixed-rate mortgages (FRMs) and adjustable rate mortgages (ARMs). A second
purpose, applicable only to ARMs, has been to reduce the potential for
payment shock -- a very large increase in the mortgage payment associated
with an increase in the ARM interest rate.
The downside of negative
amortization is that the payment must be increased later in the life of
the mortgage. The larger the amount of negative amortization and the
longer the period over which it occurs, the larger the increase in the
payment that will be needed later on to fully amortize the loan.
Negative
Amortization on Fixed-Rate Loans
On fixed-rate loans, negative
amortization is a tool for reducing the mortgage payment in the early
years of a loan, at the cost of raising the payment later on. Instruments
that incorporate this feature are called graduated payment mortgages or GPMs. There are many possible GPMs that differ in terms of the
size of the payment increase and the number of years over which increases
occur. The following is a small sampling of 6% 30-year GPMs compared to
the standard level-payment mortgage described above, and to FRMs that are
interest-only for varying periods.
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GPMs,
Interest-Only FRMs, and Standard FRMs, at 6% for 30 Years
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|
Type of
Loan
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Initial
Payment
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Highest
Payment
|
Month
Highest Payment Reached
|
Highest
Balance
|
Month
Highest Balance Reached
|
|
Standard
Level Payment
|
$600
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$600
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1
|
$100,000
|
0
|
| Graduated
Payment: |
|
|
|
|
|
|
7.5% for 5
Years
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$445
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$639
|
61
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$100,989
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24
|
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5% for 10
Years
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$425
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$692
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121
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$102,393
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48
|
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7.5% for 10
Years
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$356
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$733
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121
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$106,553
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72
|
| Interest
Only: |
|
|
|
|
|
|
For 10 Years
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$500
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$716
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121
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$100,000
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1-120
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|
For 15 Years
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$500
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$844
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181
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$100,000
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1-180
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For 20 Years
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$500
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$1110
|
241
|
$100,000
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1-240
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The first GPM calls for
annual increases in the mortgage payment of 7.5% for 5 years. The initial
payment is $445 as compared to $600 on the standard mortgage, but the GPM
payment rises to $639 in the sixth year where it remains for the balance
of the term. Negative amortization is modest, the balance rising to
$100,989 in month 24 before positive amortization begins. The other GPMs
have even lower initial payments but the ultimate payments are higher and
negative amortization is greater.
In general, the lower the initial payment
on a GPM and the smaller the payment increases, the larger the negative
amortization and the final payment. However, the final payment can be
higher on an interest-only FRM than on a GPM, depending on how long the
interest-only period is.
GPMs make sense for borrowers who can
confidently predict that their incomes will rise over time to at least
keep pace with the rising payment. A drawback is that if they sell their
house after only a few years, they will owe the lender more than when they
began. A more serious drawback is that some borrowers with questionable
prospects for the future nevertheless elect GPMs because it is the only
way they can qualify for the loans they want.
Historically, default rates on GPMs in the
US have been higher than on standard level-payment loans, and lenders have
become reluctant to make them as a result. In the relatively low-interest
rate environment of recent years, GPMs are less needed to get the payments
down to affordable levels, and they have virtually died out.
Interest-only FRMs are around but they are
used mainly for high net worth individuals with variable incomes who
expect to prepay much of the loan balance before the end of the
interest-only period.
Negative Amortization and Payment
Shock on Graduated Payment Adjustable Rate Mortgages
In the high-interest rate environment of
the early 80s, negative amortization on some adjustable rate mortgages (ARMs)
served the same purpose as on GPMs � allowing reduced payments in the
early years of the loan. Payments in the early years of these "GPARMs"
were deliberately set lower than the interest due the lender, resulting in
negative amortization. As with GPMs, the amount of this negative
amortization was known in advance.
If interest rates on GPARMs rose from
their initial levels, however, it could result in additional negative
amortization that was not known in advance. This in turn could
result in payment shock. These instruments experienced default rates even
higher than those on GPMs, and they soon stopped being offered in the
marketplace.
ARMs in the Late 90s Without
Negative Amortization
Most ARMs today do not have the potential
for negative amortization. Whenever the interest rate is changed, the
mortgage payment is adjusted immediately so that it will continue to
amortize the loan fully over the portion of the original term that
remains. On such ARMs, the mortgage payment is always "fully
amortizing".
Payment shock on ARMs that always have
fully amortizing payments is avoided by capping the size of any interest
rate increase. On ARMs that adjust the rate every 6 months, the cap is
usually 1%, and on ARMs that adjust the rate every year the cap is usually
2%. However, on ARMs where the initial rate holds for 5, 7 or 10 years and
then adjusts annually, the cap at the first rate adjustment is usually 5%,
dropping to 2% on subsequent (annual) adjustments.
The affordability of ARMs today is
enhanced not by a graduation feature but by relatively low initial rates.
In general, the shorter the period for which the initial rate holds, the
lower the initial rate.
ARMs
in the Late 90s With Negative Amortization
The most important remaining ARM with the
potential for negative amortization is the monthly adjustable -- the
interest rate is adjusted every month and there is no interest rate
adjustment cap. If the mortgage payments on such loans were always fully
amortizing, borrowers would be vulnerable to extreme payment shock. For
example, a monthly adjustable I looked at on Feb. 27, 1998 had an initial
interest rate of 7.75% and a maximum rate of 12%. If markets rates
exploded the month after this loan was closed, the rate would rise to 12%
and the new fully amortizing payment would be 71% higher.
To avoid this possibility, these loans
adjust the payment only once a year subject to a payment adjustment cap of
7.5%. In the event of an interest rate explosion, the rate would go to
12%, but instead of a one-time jump in payment of 71%, the adjustment
would be stretched out to annual changes of 7.5% over 6 years. But the
consequence of stretching out the payment adjustment is negative
amortization. For 5 years the payment would fail to cover the interest and
the balance would rise to 109% of its original value before it started to
come down.
All other things equal, caps on interest
rate adjustments are much better for the borrower than caps on payment
adjustments that can result in negative amortization. The problem is that
other things are seldom equal. The monthly adjustable described above adds
a smaller markup ("margin") to the rate index than ARMs with
rate adjustment caps, and is tied to an interest rate index that has a
lower value.
The bottom line is that it doesn't make
sense to assess ARMs in terms of whether or not they permit negative
amortization. What matters in the decision process is how the ARMs would
perform in different future rate environments. On Feb. 27, 1998 when I
looked at this, a monthly adjustable would perform better in a stable or
declining rate environment, but worse in a rising rate environment, than
other ARMs that have rate adjustment caps. However, the advantage of the
monthly adjustable in a stable rate environment was small while the
disadvantage in a rising rate environment was uncomfortably large -- for
me. I would avoid the monthly adjustable, but someone else might feel
differently.
Copyright Jack
Guttentag 2002
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