For people looking for affordable homes in hot real estate markets, the past several years have been a difficult time. Luckily, these high prices were accompanied by some of the lowest interest rates in decades. As a result, many borrowers were able to afford higher prices for their homes, because low rates helped to offset the impact of high prices on their monthly payments.
However, for many borrowers, low rates weren't enough to make their payments affordable. Some mortgage lenders responded by offering loans that allowed borrowers to lower their payments even further. Although these lenders may have used terms like "negative amortization" when describing these loans, the most important thing many borrowers heard was that they could choose a monthly payment they could afford. Unfortunately, some of these borrowers didn't know the trap they were building for themselves.
What negative amortization is
Amortization in general refers to paying back a loan in installments over time. For instance, a 30-year fixed mortgage involves payments that slowly repay the principal amount borrowed over a period of 30 years. Initially, monthly payments are composed mostly of interest; later, as the principal balance outstanding falls, more of each payment goes toward repaying principal.
The need to repay principal increases the amount of each monthly payment. With interest-only loans, the entire payment goes toward interest. Compared to a fixed 30-year mortgage, there are two major differences. First, each monthly payment on an interest-only mortgage is lower; on a $200,000 loan at 6%, using an interest-only mortgage lowers your payment from about $1,200 to $1,000 per month. On the other hand, if you only make interest payments, your principal balance never goes down, so even at the end of 30 years, you would still owe exactly as much money as you borrowed at the beginning. These loans are sometimes referred to as non-amortizing loans, because the payments are calculated never to repay the loan principal.
To lower monthly payments even further, negative amortization loans set payment amounts below the amount of interest due on the loan. For instance, depending on exactly what terms a borrower accepts, payments on a negative amortization loan can be quite a bit lower even than interest-only loan payments. With home prices as high as they have been, some borrowers had to stretch as much as they could to afford a home, and negative amortization loans sometimes gave them the extra edge they needed. However, because the payments are insufficient to cover all the interest, unpaid interest is added to principal, and the outstanding balance on the loan increases over time, rather than slowly getting paid down. Although some larger banks, such as Wells Fargo (NYSE: WFC ) and Citigroup (NYSE: C ) , choose not to make loans that required negative amortization, mortgage brokers can often find other lenders willing to make these loans.
Adjustable-rate mortgages and negative amortization
Some borrowers deliberately sought out negative amortization loans for their low payments. Others may be in a negative amortization situation without even realizing it. Many borrowers who used adjustable-rate mortgages over the past few years have started to see their monthly payments rise in response to increases in short-term interest rates. Depending on how these new payments are calculated, some borrowers may now be in a situation in which their loans are negatively amortized.
The most common way this transformation can take place is with a provision in some adjustable-rate mortgages that caps changes in mortgage payments. For instance, if your initial monthly payment on your loan is $1,000 per month, a loan could specify that under no circumstances would the monthly payment exceed $2,000 per month. However, if interest rates rose enough, then even a $2,000 monthly payment might not be enough to cover the interest on the loan, thereby converting what was initially a loan with normal amortization characteristics into a negative amortization loan.
When housing prices don't cooperate
As long as housing prices were appreciating rapidly, negative amortization loans didn't pose that much of a problem. After all, if you paid $200,000 for a house that you sold five years later for $400,000, you didn't really care whether your outstanding mortgage balance was $187,000, $200,000, or $215,000 -- you still pocketed a nice profit, even after repaying your mortgage.
However, the combination of negative amortization loans and flat or falling home prices can be devastating to homeowners. Month after month, the insufficient payments create negative equity in your home. When you sell, you may discover that you have to make up not only any decline in the price of your house, but also the amount of additional principal that resulted from the negative amortization. This can present homeowners with an unsolvable dilemma; if they keep the house, they will continue digging an ever-deepening hole, but they can't sell because they can't afford to make up the deficit on their mortgage.
What to do
Unfortunately, the best solution to borrowing woes is to avoid overextending your credit in the first place. However, once the damage is done, you should do whatever you can either to make more than your minimum monthly payment on your loan or to set aside funds in a separate account that are dedicated to repaying any negative equity in your home, should you choose to sell. If you had to get such a loan in the first place, it goes without saying that finding this extra money may be extremely difficult. Nevertheless, it's the best way to address the problem early, before it grows into something beyond your control.
Negative amortization loans are the only way some homeowners can buy their homes, but they present a trap for the unwary. Only by managing your finances carefully can you avoid a potentially disastrous result.
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Fool contributor Dan Caplinger cringes at the thought of the mortgage he'll be getting soon. He doesn't own shares of any of the companies mentioned in this article. The Fool's disclosure policy never charges you interest.