ARM terminology is confusing to borrowers, so let’s begin by defining some terms. First I’ll discuss the most difficult concepts: negative amortization and its counterpart, the no-neg loan.
A common feature of the COFI loans that have been very popular in some parts of the country are negative-amortization, or neg-am, loans. The etymology of the term amortization is unpleasant: Its root is the French word mort, meaning death. Over time, the balance on an amortized loan is reduced to zero. Thus, as you make the payments, the loan “puts itself to death.” In a neg-am loan, it is possible to make payments that are less than the amount necessary to amortize the loan. In fact, sometimes the obligatory payment isn’t even enough to pay the interest that is accruing monthly on the loan.
During such periods, the loan balance isn’t going down (amortizing), but going up! That’s why it’s called a negative-amortized loan. I prefer the phrase “a loan with the potential for accrued interest,” but because everyone else calls it neg-am, so will we. Before we get into the specific mechanism of the neg-am loan, I want to discuss its counterpart, the no-neg loan.
If it weren’t for neg-am loans, the expression no-neg wouldn’t exist. A no-neg is a normally amortizing loan. The change mechanism limits the amount by which the interest rate can change, typically 2 percent per year; you then pay whatever you owe each month. If the rate changes every six months, there is a 1 percent limit on the amount of change. Regardless, within any period during the life of the loan, your monthly payment is sufficient to amortize the loan. The loan balance never increases, so it is always a “positiveamortization” loan, if you will. The term no-neg is really a doublenegative, but, again, that is what the industry calls it. All no-neg loans have a ceiling rate, frequently 6 percent above the start rate, giving rise to the industry terminology, 2/6 no-neg. No-neg loans are a favorite of banks and Wall Street.
You can see that the rate rose by the 2 percent limit in the first year, from 6 percent to 8 percent. Without the limit, it would have gone up further. In the following years, it moved up and down as index plus margin moved. You can see that the 2 percent limit works both ways because, in late 1991, the interest rate on the loan would have dropped more than 2 percent had it not been for the limitation.
With a negative-amortization loan, the lender “disconnects” the payment rate from the interest rate. You make a payment that over a long period of time follows interest rate fluctuations but is not directly connected to the rate. Usually, the loan’s initial rate is deeply discounted. I’ve done loans with start rates as low as 2.95 percent. This is the actual interest rate but, take note, only for the first three months. The interest rate adjusts upward to index plus margin (covered later) in the fourth month.
For the balance of the loan period, another 357 months, the interest rate is adjusted every month. It is important to realize that regardless of what interest rates do, the annual payment adjustment whether increasing or decreasing is limited to a 7.5 percent adjustment from the payment of the previous year.
Our website is not responsible for the information contained by this article. Articleinput.com is a free articles resource thus practically any visitor can submit an article. However if you notice any copyrighted material, please contact us and we will remove the article(s) in discussion right away.
Note: This article was sent to us by: Stefan T. at 05042010
1. Life values and how we spend our money
All articles are property of their respective authors. Please read our Privacy Policy!
© 2009 ArticleInput.com.