By Dian Hymer
Some mortgage lenders offer a 1 percent mortgage. This may sound like the answer to your home buying dreams. However, even though you save money on monthly mortgage payments with this type of loan, you can also lose your equity to negative amortization.
The 1 percent mortgage product is a pay option adjustable-rate mortgage (ARM). With a pay option ARM, you have four monthly payment options: minimum payment (often 1.25 percent with a 1 percent mortgage product), interest-only and fully amortized 30-year and 15-year payments.
Like all AMRs, a 1 percent mortgage is tied to an index (MTA, COFI or LIBOR) that fluctuates. The lender adds a margin (the lender's profit) to the index, to determine the full amount you owe each month. This is called the fully indexed interest rate.
For example, let's say your 1 percent mortgage is tied to the MTA (Monthly Treasure Average), which is 2 percent. Your margin is 2.3 percent. For the first month of the mortgage, you only owe 1.25 percent. Starting with the second month, you owe the fully indexed rate, or 4.3 percent.
If at the second month, you elect to make the minimum payment, the amount of the unpaid debt is added to the amount you borrowed. So rather than reducing your debt, the debt grows. This is called negative amortization or deferred interest. You can avoid negative amortization by making an interest-only or a fully amortizing payment.
Lenders have limits on how much negative amortization they'll allow before they require the borrower to start paying back what they borrowed. Typically, when the deferred interest reaches 110 percent or 115 percent of the original loan amount, the lender will "recast" the loan.
At this point, a payment schedule is set up so that the borrower repays the mortgage based on the fully indexed rate at that time. This can result in much higher monthly payments, particularly if interest rates have skyrocketed. This is one of the risks of a negative amortizing mortgage.
Negative amortization can be offset by home price appreciation. However, if home prices drop, as they did in many areas during the early 1990's, you could find yourself owing more than your home is worth. It's risky for buyers to stretch to buy using a 1 percent mortgage, and then make a habit of paying only the minimum amount due each month.
HOUSE HUNTING TIP: Although a pay option mortgage is not for everyone, some borrowers find it an excellent way to manage money because it allows them flexibility. Borrowers who work on commission, or who have a lot of assets but minimal cash flow, find pay-option loans a boon. It allows them to make minimal monthly payments when the cash flow is lean. When the money starts flowing, they can pay back deferred interest and pay down the principal balance.
If you do elect to use a pay option mortgage, make sure you understand how it works before you commit to taking the loan. You have a choice of index, which will fluctuate over time. Ask your mortgage representative to explain each index, including what the loan will look like in a worst-case scenario of much higher interest rates.
The margin will be set for the loan term, so the lower the margin the better. You can usually pay more in upfront fees (called points) to buy down the margin. For instance, you might pay no points for a 2.3 margin, or 1 point for a 2.05 margin. One point is equal to 1 percent of the loan amount. It may be worth your while to do this if you plan to keep the loan for a long time.
THE CLOSING: 1 percent mortgages are usually only available to borrowers with sterling credit.
. Questions of a Do It Yourself nature should be submitted our "