by Tanya Davis
For people who are interested in having flexible payment options, a flat minimum payment sounds like a dream. Sometimes called Pick-a-payment mortgages, they are marketed with names such as "stress-free mortgages." These loans allow a borrower to choose their minimum payment or an interest-only payment. They can also choose whether to amortize loan over 30 years or 15 years. Often the payment they choose is as little as one percent.
These loans certainly sound as if they could be stress free. This would even allow a borrower to buy a lot more “house” for the money. But if a person chooses to pay only 1% on their loan as the minimum payment, that's where the trouble begins. By paying less than the interest rate, the borrower is deferring part of the interest that they owe. This deferred payment is added back to the balance of the mortgage -- month after month. Since the payment doesn't touch the principal, the loan is actually growing over time -- resulting in negative amortization. The interest continues to grow until a certain threshold is reached. Usually, this limit is 110 to 125% of the original loan balance. At that time, the borrower is no longer allowed to make the 1% minimum payment. The loan is reset with a new monthly payment -- one that is much higher than the initial 1%. Once the loan is reset, the borrower often cannot afford the monthly payment.
Considering that these loans have typically been offered to people who did not qualify for conventional mortgages in the first place, and now the principal of the mortgage is bigger than ever, one can see why lenders jokingly referred to pick-a-payment loans as "pick a foreclosure loans." In 2004, 1/3 of all mortgages in the United States were interest-only or flat minimum payment loans.
Who Should Choose a Flat Minimum Payment Loan?
Mortgage experts say that this type of loan can create real disaster for most families. A borrower should only take on this kind of risk if he or she knows for sure that the house will appreciate substantially, that interest rates will either remain the same or fall, or that the family income is going to significantly increase. If any of these do not occur -- if interest rates go up, property values go down, or income remains the same, the borrower will likely find himself in financial trouble at the end of the term.
Tanya Davis is a freelance writer living in Tennesee.
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