Let’s take a moment to talk about pick-a-pay mortgages, otherwise known as negative amortization loans, which have surged in popularity in the last five years – so much so that they’ve been highly featured, and in turn scrutinized, from USA Today to the cover of BusinessWeek.
The pick-a-pay mortgage is a complicated loan. Most consumers don’t really know what they’re getting aside from the super low minimum payment option, mainly because brokers and loan officers tend to push that aspect of the loan above all else.
Pick-a-pay mortgages carry four “flexible” mortgage payment options, including:
– Minimum payment (usually as low as 1%)
– Interest-only payment
– 30-year fully amortized payment
– 15-year fully amortized payment
The minimum payment is the focal point of all the scrutiny. If a borrower decides to pay the minimum payment, they essentially pay less than the actual interest rate on the loan. In doing so, they defer the actual interest owed.
The owed interest begins to build up on top of the existing loan balance until a set limit is reached, which ranges between 110-125% of the original loan balance. Once this limit is reached, the borrower loses the ability to use the minimum payment option and the loan recasts with a new minimum payment that will be substantially higher than the 1% start rate.
This is the point where serious problems arise. For example, a $500,000 loan amount with a 7.5% mortgage interest rate would carry a 1% minimum payment of $1608.20, while the interest-only payment would be $3,125.00.
If the borrower chooses to pay the 1% minimum payment each month, they would be tacking on nearly $1,600 in owed interest each month. To add insult to injury, the interest rate is adjustable, so that payment will likely keep increasing as the mortgage index goes up during the life of the loan.
To make matters even worse, once the borrower loses the ability to the pay the minimum payment, they owe anywhere from 110-125% of their original loan balance, so they’re faced with a substantially higher monthly payment on a higher overall loan balance.
In the above example, a borrower would lose the minimum payment option in three to five years if they chose to pay the minimum payment each month. At that point the loan would recast and they’d likely find themselves in a big hole with an unmanageable mortgage payment.
This wasn’t a problem in the last few years as house values increased year after year at a higher rate than associated interest rates, but things have changed. Values now are either stagnant or dipping. There isn’t an easy exit strategy anymore. Those looking to refinance or sell may have to bring money to the table, an option many of these homeowners simply don’t have.
Many might ask why these mortgages were ever created and where they went wrong. The simple truth is these mortgages were originally created as a means of flexibility, not a way of avoiding your actual monthly mortgage payment.
In a perfect world, a borrower would pay the minimum payment one month, then the fully indexed rate another month, as needed. Typically, borrowers with little self-control began exploiting the system by paying the bare minimum every month. At the same time, brokers and loan officers began pushing these loans hard as banks offered rebates (yield spread premium) of up to 3.5% on the back-end.
Ultimately the borrower is responsible for his or her own fate, but the misdirection from mortgage brokers, loan officers, and mortgage lenders should be taken into account as well. More documentation should be available to those selling these loans and those buying into these loan programs.
The ironic part of all this is that the pick-a-pay mortgage program extended the mortgage refinance and purchase boom longer than it could or should have gone. Once these loans recast in the next few years, most homeowners will likely refinance into a fixed-rate mortgage, essentially creating a new mortgage boom.