By Trish Signet, Loan Officer, Summit Mortgage

With interest rates rising steadily over the last few years, it's become somewhat harder for property investors and others to make the numbers work.

For example, that same rental property whose tenant-generated cash flow may have covered all of the monthly mortgage burden as recently as three years ago, may no longer be self-supporting. Higher rates mean higher mortgage payments, and the differential can often squeeze cash-flow-strapped investors out of the market.

Negative amortization mortgages can help... but beware, with the significant benefits come equally significant risks.

First, let's make sure we understand the concept. Fannie Mae defines negative amortization as follows: "An increase in the balance of a loan caused by adding unpaid interest to the loan balance; this occurs when the payment does not cover the interest due."

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In other words, rather than paying a piece of the interest and principal each month as occurs with a typical mortgage, with negative amortization, the borrower pays no interest and (typically) only part of the principal with each payment. The part that isn't paid each month gets added back on top of the original loan amount. Since amortization means "paying back," a loan in which the amount owed grows each month is a "negative amortization loan."

Naturally, there are advantages to this type of arrangement:

1. Lower monthly payments. Since you are not paying the full interest due, and often only some of the principal, your cash flow is better.

   For example, on a $300,000 mortgage, with a 30 year fixed rate of 6.50%, the fully amortizing principal and interest payment would be $1,896 per month. On a negative amortization loan of the same amount on the other hand, the minimum monthly payment could be as low as $1,035! A huge difference, amounting to over $10,000 per year in total payment savings.

2. Payment flexibility. Many negative amortization programs offer the choice of paying the fully amortized payment, the minimum payment, or an interest only payment each month. That flexibility can of course be helpful, particularly if you find yourself temporarily without a tenant, or if an unexpected - but urgent - property expense suddenly arises. When these short term emergencies are taken care of, you can go back to making full payments.

3. Interest deferral as a tax strategy. Since interest payments are recognized in the year that they are paid, some investors deliberately try to match these payments with income recognition which may not occur until a later time. The ability to defer interest payments under a negative amortization loan may allow an investor to better manage the tax implications of investment property ownership (check with your accountant on this one, since the specifics will vary).

Those are the advantages. As mentioned earlier however, there are disadvantages as well with this approach:

1. Instead of building equity, you may be losing equity. With a standard mortgage, your monthly payments reduce the size of your debt. Month after month, year after year, if you keep paying the full amortization amount over the term of the loan it will eventually drop to zero.

   With negative amortization however, you're not reducing the size of your debt each month, you're adding to it. Combine that with the drop in real estate values that we've seen recently, and you could easily find yourself holding a mortgage in excess of the value of the property itself! At that point, if you want or need to sell the property, the loan you need to pay off would be higher than the amount of cash generated by a sale. Under these circumstances, you would literally have to raise cash from another source simply to get out from under the property.

2. Negative amortization specifics can be confusing. To many people, the terms "negative amortization" and "interest only" are very unfamiliar. In addition, the various payment options can make planning for and paying your mortgage on a monthly basis more complicated than you may like. A negative amortization loan requires more work on the part of the borrower, and requires a greater amount of education regarding the program being signed on to.

3. Too much flexibility. Flexibility cuts both ways, and while it's nice to have the option of choosing a lower payment on a month by month basis when necessary, it can be a very slippery slope. Unless you are naturally well disciplined - so that you make the complete payment and only drop to a lower level when needed - you run the risk of never digging out from under your mortgage debt.

Negative amortization, like many other creative lending options newly available in recent years, allows many investors to get in the game, who previously might have had to sit on the sidelines. Buyer beware however... with these new opportunities come new risks as well.

Trish Signet, Loan Officer, Summit Mortgage. With over 10 years experience in the mortgage business, Trish works with each and every client to identify the mortgage financing options that are best suited for both their short and long term financial goals. She may be reached at 781-541-6410, tsignet@summitmortgage.com or online at Summit Mortgage.

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June 2006

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