Interest-Only Payments and Negative Amortization
Keeping the early mortgage payments as low as possible is a recentconcept that has made loans possible for many real estate investors.To understand how this works, it may be helpful to look for a moment at the basic mortgage process. In a mortgage, monthly payments by the borrower do two things: pay the interest charged by the lender and gradually pays back the amount borrowed, or principal. For example, in a thirty-year fixed rate mortgage of $100,000 at six percent interest, the monthly payment is $600. Of that $600 payment, $500 is interest and $100 goes to paying off the principal (amortization). A monthly payment of $600 would pay the mortgage in full in thirty years, both interest and principal. It is thus known as a fully amortizing payment. Obviously payments of more that $600 a month would pay the mortgage in less than thirty years. Payments of $550, known as partially amortizing payments, cover the interest due but cannot pay back the principal in full within the thirty-year term of the loan. Payments of only $500 a month would just cover the interest due, without any amortization. At the end of thirty years, the borrower would still owe $100,000. These are known as interest-only payments.
To keep early payments as small as possible, some loans today have interest-only payments in the early years, and in later years have fully amortizing payments. If $500 interest-only payments were made for the first five years of the thirty-year fixed rate mortgage above, the fully amortizing payments of the remaining twenty-five years would be $644.
Taking this a step further, it would be possible to make only $400 payments on the mortgage. With payments of this amount, none of the principal would be paid back and each month the shortfall of $100 in interest payment would be added to the principal. This amounts to the lender extending an additional loan of $100 each month to the borrower, in a process call negative amortization.
Negative amortization has been offered with both fixed rate mortgages and adjustable rate mortgages (ARMs). A fixed rate mortgage in which negative amortization reduces early payments at the cost of raising later payments, is called a graduated payment mortgage (GPM). GPMs differ widely in interest rates, payment amounts and times involved. Because of current low interest rates, there is almost no market for GPMs today.
In most ARMs, the payment is always fully amortizing. In monthly adjustable ARMs with no rate adjustment cap, a negative amortization option may be offered to offset extreme payment shock in the unlikely event of a steep rise in the interest rate.
