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Financial Literacy

Financial Literacy

Home Financial Literacy Mortgages Negative Amortization

Negative Amortization

A “neg am” loan is one in which the principal actually grows over time rather than shrinks, as one would intuitively believe if one were “paying off” a loan. Why would someone not pay off a loan? The most common reason is they expect to die at some point in the not too distant future. Like if you are elderly, have a disease, or are especially klutzy.

Grandmama owns her home in Beverly Hills worth $4 million. She has $300,000 left on the loan that she and her now dead husband took out 17 years ago. She needs cash to live on so she can take you out for fancy steak dinners in her well-appointed Cadillac Seville. To pay the waiter, she switches to a negative amortization loan in which she pays much less than the interest she would normally pay to “break even” on the loan, leaving her principal flat. Suppose she is 90 and coughs a lot between cigarettes while engaging in hang-gliding adventures; if she lives 10 years, her loan might be $500,000. The home is sold for $4,000,000 and you as sole heir collect $3.5 meg pre tax. Miss you Grandmama, but cha ching.

Negative amortization loans are typically structured like an ARM (adjustable rate mortgage). There is usually a cap (maximum interest rate), a step up rate (amount which the interest can go up each year once the teaser period is over) and an index (such as LIBOR or a Treasury Index). The beginning rate can be really low (1-2%) but it can reach as high as 15%. Also, because the interest payment does not cover the fully amortized loan, each month the principal gets bigger.

Note that retired people sometimes also do a reverse mortgage. (This is also how many of them drive down public roadways.) The person sells a piece of his/her home but still lives there and has no mortgage payments until the home is sold or the person dies. Again, as long as the mortgage is lower than the overall value of the home, the heirs gets something at the end.

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