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Negatively Amortising Mortgage - Beware!

When you are ready to buy your dream home, give it a lot of thought. Especially when it comes to how much you can afford. Once you figure out how much you can afford, things become easier. The next thing to do is to find a mortgage broker, get a good deal and get pre-approved. You then begin your house-hunt through a realtor, hopefully representing you and not the seller. If the home is within your budget, fantastic....you're home!!

The problem arises when you don't do your math properly or in the worst case scenario don't do it at all! You find your dream home and only then start the approval process with a mortgage broker. Since you are in such a hurry to close the deal or else risk losing the home to the next bidder, you rush through the mortgage approval process. This is exactly what you should avoid.

These days, a huge percentage of home buyers -- up to 50% in some areas, according to various reports -- are taking advantage of interest-only loans. One of my friend got a call from a mortgage broker where the broker quoted a very low interest rate - 1.95% 5/1 ARM. This was great offer, or so he thought. Little did he realize that the mortgage he had taken out was a negatively amortizing loan.

With most home mortgages, the payment you make each month goes toward paying the interest and the principal. As you continue to make your payments, the outstanding principal on the loan reduces bit by bit -- and the amount of principal you pay off each month grows. That's how you can pay off your home by the end of the loan's term. That's how regular mortgages work.

But the negatively amortizing loan works differently. It is just like a credit card with a huge balance. While the minimum payment due every month is quite low, it isn't enough to cover the interest accrued. The difference is added to the amount you owe from the previous month, and as a result, the total you owe continues to rise.

This is exactly how the negatively amortising mortgage works. To put in simpler words, despite the fact that you're making the required payments, the real amount needed to pay for that house continues to rise. When it reaches, say, 110-125% of the original purchase price, the loan converts and you are expected to pay the whole amount of the new principal and interest every month.

To help explain just how quickly you can get yourself into trouble with a loan like this, here's an example: Imagine you buy a home in the San Francisco Bay Area after borrowing $700,000. Assume that you make your minimum payments at the 1.95% rate my friend got quoted. By the time 3 or 5 years of the loan term have passed the loan is amortized over 30 years at a new, higher interest rate, let's say 7.50%, you are now taking out a new loan for $750,000 or more for a home that you bought for $700,000 three or five years earlier! Suddenly, your monthly payment jumps from $1998 to around $5008!! I've just pulled the numbers out of thin air, but you get the point, right?

The easiest way to avoid this kind of misstep is to buy a home you can afford and by properly doing your math, even if you learnt it high school. But if you're determined to get out there and pay any price to get your dream house, at least stick with a more traditional ARM, or even an old-fashioned fixed-rate mortgage.