Negative Adjustable-Rate Mortgages Offers Debut

Adjustable-Rate Mortgages are one way for homebuyers to structure their purchase with lower monthly payments—at least at the beginning. five- or ten-year ARMs allow borrowers to take advantage of cash flow savings at a “teaser” rate for the initial term of the agreement, after which payments adjust to a new, higher rate. The amounts are calculated according to a formula that adds a margin to the then-current indexed interest rate.

Since future rates are not known, there is an element of hold-your-breath unknown risk involved, which many borrowers find unappealing. It does make good sense in some circumstances—for instance, when a borrower knows for certain that their income will rise greatly in the future—or when a move is likely before the reset date. But there are also some other brain-taxing possibilities. If the maximum allowable increase (the “cap”) creates a payback figure that is less than the rise in the indexed interest rate, a negative amortization results—meaning the loan balance owed goes up after each payment.

That unpleasant situation is now making a limited return, according to officials at one San Diego-based bank. Their “mind-blowing, inflation-busting” new home loan alternative specifies a deferral rate—which is the overall note rate minus a deferred percentage (2.75% is given as an example). The difference in cash savings is added to the loan balance each month. At the end of the term, the rate reverts back to the overall note rate—now calculated for the increased balance. As you might imagine, the new payment amount could be significantly higher.

If that sounds like the kind of exotic loan that led to the bad old days of the Great Mortgage Meltdown, you’re not alone. The Consumer Financial Protection Bureau says that for all the mortgages with exotic features that originated between 2005-2007, more than half defaulted within a couple of years. But the San Diego lender—Axos Bank—isn’t worried. Borrowers will “have to jump through extra hoops to prove the ability to repay.” You might wonder why, if they are such gold-plated customers, they would be attracted by such extreme cash-saving features. One answer might be a gamble on considerable future inflation, which makes dollars saved today more valuable than those spent later. Fortunately, exotic home loans aren’t the only alternative for today’s homebuyers.