Negative amortization or “neg am” occurs when the minimum payment on a mortgage covers less than the monthly interest charged, causing the balance of the loan to increase instead of decrease. Interest Only Loans generally don’t increase the balance due on a home although they don’t diminish the amount due. However, deferred interest loans will increase your loan amount. This can happen with negative amortizations loans, like a Payment Option ARM, where payment choices can be calculated based on certain indexes used for these loans, giving you a variety of choices in payments. They are also known as “Pick a Payment Loans.” While these loans can be a good deal when short-term interest rates are low, they are not necessarily the right choice when short term loans have a higher interest rate.
If you are looking to eventually cash out home equity, you should look for a purchase loan that involves paying some of the principal. Not only is it possible you may not build equity in your home with neg am loans, you also may have a loss of equity through an increased mortgage balance. If you suddenly need to sell your home, you may not be able to get a purchase price high enough to cover your loan. You will also have more difficulty getting a second mortgage behind negative ARM loans.
On a deferred mortgage, the mortgage balance can increase as much as $350 per month for every $100,000 that’s borrowed. The neg am on a $500,000 loan for example, can be as much as $1,750 per month. While there are not many circumstances where I would recommend an Option ARM, there are a few instances where deferred interest or negative amortization loans may make sense.
Neg am loans are good for investment properties when you may be paying a double mortgage. They are also good for self-employed individuals with cash flow issues. If you plan on normally paying some of the principal, but don’t know what your cash flow will be like from month to month, it may be helpful to have the option of a minimum payment.
Do your homework before deciding on a deferred interest mortgage. Although your payments will be lower, there are inherent risks involved and you may be better off with a fixed-rate mortgage.