1) 15-year fixed payment, 2) 30-year fixed payment, 3) Interest-only payment, & 4) Partial-interest payment (1%-3%).  The payment options will look something like this:

As you can see there are significant differences in the monthly payment amounts.  The 15-year payment option will allow the borrower to completely payoff the mortgage in 15 years providing that payment amount is made each month.  The 30-year payment option will allow the borrower to completely payoff the mortgage in 30 years providing that payment amount is made each month.  The interest only payment option allows the borrower to simply pay only the interest portion of the loan and none of the principal.  The low-rate payment option allows the borrower to pay a very small portion of the interest and none of the principal, creating negative amortization.  With negative amortization, the remaining portion of the interest that is not paid is added to the principal balance owed.  In the numbers above, if the low-rate payment is made each month for 30 years, a total amount of $302,270.40 ($839.64 x 360 months) will be added to the principal amount of $300,000.  Therefore, at the end of the 30-year term a balloon payment of $602,270.40 will be due.  “Bad Loan,” Right? 

Let’s look at three scenarios:

Scenario One

You have a working family that’s looking to buy a new home for $300,000 that they can use to leave as an inheritance to their children.  They have a combined monthly income of $4200.  Their lender, knowing the family really only qualifies for a $150,000 home, tells them they would qualify to purchase the $300,000 home utilizing the Pay-Option ARM with a $1035.36 monthly payment.  They make the $1035.36 monthly payment for 360 months (30 years), with a minimum understanding the loan product.  They don’t realize the amount of negative amortization that this payment creates, because their lender didn’t bother to explain the entire deal.  They mail in, what they believe to be, their last payment and they receive another statement with balance due of $602,270.40.  They are now retired, living on a fixed income, and have no means of satisfying the due balance.

Scenario Two

You have another working family that’s looking to buy a new home for $300,000 that they can use to leave as an inheritance for their children.  They have a combined monthly income of $7600.  They have expressed their goals for the property and their lender has located a product that could meet their circumstances.  The lender suggests that they utilize the Pay-Option ARM and explains in detail the four payment options.  The lender goes on to show them how to make the most use of the low-rate option payment.  They decide to make the $1035.36 payment for 360 months (30 years) and take the other $839.64 (that would’ve gone toward the interest owed) to make a long-term investment yielding a 10% annual return.  They mail in their last payment of $603,305.76 ($602,279.40 + $1035.36), which they deducted from the $1,657,389.14 that they made from investing.  They are retired, the children are gone and they are ready to starting living the rest of their life with $1,054,083.38 left over.

Scenario Three

You have an investor that has located a foreclosed property for $300,000 on an excellent block.  The property needs cosmetic work and has minor county violations.  Comparable properties are selling for over $450,000 with a 90-day average market time.  The investor knows that it will take a maximum of 30 days to complete repairs & updates at a cost of $10,000.  The investor contacts his lender who recommends the Pay-Option ARM.  The lender explains that the investor can make the low-rate option payment of $1035.36 for the estimated 4-month period until the property is sold.  The lender explains that making the low-rate option payment will create $3,358.56 in negative amortization for the 4-month period, increasing by $839.64 each month thereafter.  The lender goes on to explain the other payment options, should unforeseen circumstances arise.  The investor sells the property in 180 days for $445,000.  After deducting the $305,037.84 mortgage payoff, $10,000 repair cost, $6212.16 holding costs, $16,000 combined closing costs, he has a gross profit of $107,750.

The first two scenarios above are somewhat exaggerated, because most of the Pay-Option ARM products have stipulations that won’t allow the minimum payment to be paid for a 30-year period.  However the point made in the scenarios are still valid and you can see that is not a “Bad Loan” if used in the right situation.  It is a loan product that should be used as an investment vehicle.  Similar scenarios have played out with other products on the market that have been labeled “Bad Loans.”  Understand that the issue we are facing today is not the result of bad loan products, but the result of dishonest, unethical, and/or ignorant lenders putting borrowers in the wrong products for their situations.  A good lender is able to take your scenario and find appropriate products that would be beneficial.  In addition, this lender will thoroughly understand and explain the pros and cons of the potential products to you.  In essence, being successful in the real estate game requires a knowledgeable team of professionals and a good lender is an essential part of team. 

Anita Clinton is a licensed Loan Originator/Real Estate Broker for Investors, a part of the editorial staff for Invest With Passion! Magazine, and the founder of www.OwnSomethingToday.com.  She can be reached at 708-491-7394 or ownsomethingtoday@yahoo.com.