Understanding How The 1% Mortgage Loan Works...
By Terrence J. Stafford (ts@ultra123.com) & Joel M. Berinson (jb@ultra123.com)
March 25, 2007
It is a well known fact that borrowers are faced with a myriad of choices when applying for a new mortgage loan these days.
Fixed rate, variable rate, and hybrid adjustable rate loans are now commonplace and within reach of just about everyone these days. So is it any wonder that it’s become increasingly difficult for a borrower to understand which loan program is truly the best loan for them?
One of the more popular and well-debated mortgage loans over the past few years has become what is commonly known as the payment option mortgage or pick-a-pay home loan. These are the loans that are often advertised as 1% home loans because they offer the borrower the option to make a payment based upon a very low payment rate.
What has become apparent recently is that there is so much confusion surrounding these loans that many people automatically write them off as either good or bad – without really taking the time to fully understand what makes them tick or how to take full advantage of them.
It is important to understand that the payment option mortgage loan is not a new concept in home loans or to the lending industry. This loan program has been around for over 20 years and was originally designed for “investors” who wanted to be able to free up some of their monthly cash flow so that they could channel these funds into opportunities that would allow their money to work for them.
There are as many variations on the name of this loan depending upon the corresponding index that the particular loan program is tied to. Suffice to say the list is a long one and commonly used indexes are the: COFI, COSI, CODI, MTA, LIBOR, etc… (in case you were wondering - COFI, CODI, COSI, MTA, & LIBOR – are all acronyms for the names of indexes that these loans are tied to)
When determining which index should be used, thought should be given to several factors including current market conditions and the likely useful life of the loan among other factors.
The bottom line is that these loans have become very popular because they are ultimately designed to give the borrower maximum payment flexibility on a month-to-month basis - thus providing the borrower with the ultimate control over how they pay their mortgage loan.
The one obvious benefit is that they offer the borrower the option of a mortgage payment that is much, much lower that they could ever hope to achieve with a conventional fixed rate or adjustable rate mortgage.
The payment option loans available today can present a tremendous opportunity to a borrower if utilized correctly. On the flip side – if a borrower does not invest the time up front to fully understand the mechanics of these loans and how they work, they could ultimately be disappointed in them.
To help someone understand how a payment option mortgage works, a good place to start would be to understand a traditional mortgage product which most people are very familiar and comfortable with.
With a traditional fixed-rate mortgage, the loan is amortized (paid off) over a set number of years determined by the borrower at the time of application. The most common choices are usually 10, 15, 20, or 30 years.
To figure out the payment on a fixed rate mortgage one needs to know 3 factors: 1. Loan amount 2. Term (number of years to be paid off) and 3. Interest Rate
Let’s look at the following scenario as an example:
Tom and Julie own a home that is appraised at $320,000. They are looking to borrow $250,000. They would like a fixed rate mortgage at 6.5% and would like to pay off their mortgage in 30 years.
1. Loan Amount: $250,000
2. 30 years (360 months) 360
3. 6.5% (fixed rate) 6.5%
PAYMENT: $1580.17
This is a fairly simple calculation once we understand the 3 factors above (loan amount, term, and interest rate). For your convenience, you may find some handy mortgage calculators right here.
For reference: “fully amortizing” - means the loan is paid off in full at the end of the term provided the principal and interest is paid each month for the life of the loan.
With this type of loan Tom and Julie would make a payment of $1580.17 (principal and interest) and their loan would be paid off in 30 years. (Please note: Tom and Julie’s loan could be paid off sooner if they decided to pay extra each month or decided to payoff their loan with the proceeds from a sale of their property or the proceeds from a new loan or by even using their own assets to pay off the loan)
With a payment option loan things become a bit more complicated because of the monthly payment options available to the borrower.
Instead of having just 1 monthly payment “option” (like the $1580.17 as referenced the example above), Tom and Julie would now have 4 different options that they could elect to pay based upon their month-to-month budget and financial objectives.
Let’s look at the following scenario as an example:
1. Loan Amount: $250,000
2. 30 years (360 months) 360
3. 1% “pay rate” or 7.5% fully indexed rate 1% or 7.5%
PAYMENT: (Tom and Julie get to pick 1 of the following 4 payments every month)
Option 1: (minimum payment at 1%) $804.10
This option gives the lowest monthly payment – but adds “deferred interest” also known as “negative amortization” to the outstanding principal balance of the loan. This means that the outstanding balance of their loan is going to increase each month that Tom and Julie make this payment. In essence they are adding $758.40 each month to the balance of their loan for each month that they opt to make the minimum payment. (Note that $758.40 is the “difference” between their interest only payment at 7.5% ($1562.50 as referenced in “Option 2” below) less their minimum payment at 1% ($804.10).
$1562.50 – $804.10 = $758.40
If Tom & Julie were to continue to make this minimum payment for 12 consecutive months their loan balance would be $259,100.80
$758.40 (deferred interest) x 12 months = $9100.80
$250,000 (original loan amount) + $9100.80 (deferred interest) = $259,100.80
If you are following along here the first question that probably comes to mind is that this type of arrangement doesn’t seem to make sense? Why would anyone be interested in this type of home loan you might ask?
In order to answer this question we need to take a look at the bigger picture in order to fully understand why and how people are using this loan program to their advantage.
When weighing the facts, one also needs to balance the potential for “deferred interest” ($9100.80 above) with the fact that a home is an asset that appreciates on average 3%-5% per year. So if the value of Tom and Julie’s home was appraised for $320,000 when they took their new payment option loan, it is conceivable that their home may be worth $329,600 ($320,000 x 3% = $9600) after 12 months based upon a conservative annual appreciation of 3% per year.
So exactly what has happened in this example?
The value of their home has gone up to $329,600
The balance of their loan has gone up to $259,100.80
After 1 year of having this loan, Tom and Julie’s “net equity position” has actually increased (albeit ever-so slightly) when taking into account the 3% appreciation on their home as well as the “deferred interest” on their loan. Basically, they haven’t lost any ground and have gained only a very minimal amount of equity buildup in their property due to the 3% appreciation they have experienced on their home.
Now let’s take this 1 step further:
What if Tom and Julie decided to take the extra monthly cash flow (roughly $775 per month - based upon the difference in monthly payments between the fixed rate mortgage payment of $1580.17 less “Option 1” minimum payment of $804.10 from the example above) that they now have and were to invest this money? They would have $9300 at the end of year 1 without earning a dime of interest on that money. If they decided to invest in something that offered them a modest return on their money, they may have even more money saved at the end of year 1.
Or
What if Tom and Julie decided to use the extra monthly cash flow to pay down their outstanding consumer/credit card debt which they are currently being charged 10%-20% for?
The point here being is that as we dig a bit deeper into understanding the bigger picture, the payment option loan program can work very well when (and only when) utilized in the correct manner by the borrower.
Option 2: (interest only – at fully indexed 7.5%) $1562.50
This option pays only the total interest due on the loan. It does not pay off any principal unless Tom and Julie were to pay extra each month to do so. Furthermore, since Tom and Julie are paying the full interest on the loan, there is $0 deferred interest (negative amortization) being added to the outstanding balance of the loan itself.
After year 1, Tom and Julie’s equity position would look like this after factoring in a modest 3% appreciation on their home:
Value: $329,600
Loan Balance: $250,000
Option 3: (30 yr – at fully indexed 7.5%) $1748.04
This option is paid in full after 30 years if this payment is made each and every month and the rate were to stay at 7.5%.
After year 1, Tom and Julie’s equity position would look like this:
Value: $329,600
Loan Balance: $247,774
Option 4: (15 yr – at fully indexed 7.5%) $2317.53
This option is paid in full after 15 years if this payment is made each and every month and the rate were to stay at 7.5%
After year 1, Tom and Julie’s equity position would look like this:
Value: $329,600
Loan Balance: $240,940
Please note the following terminology used in reference to the payment option mortgage programs available today:
“Pay Rate” – is the introductory rate allowed for a certain period of time as determined by the individual lender.
“Fully Indexed Rate” – is determined by adding 2 factors together: The “Index” + The “Margin” = The Fully Indexed Rate.
The Indexes used for these loans are many. It is important to note that there are many “variations” of this product offered by many different lenders. The more common indexes are the COSI, COFI, CODI, MTA, & LIBOR indexes. Each one of these indexes have positives and negatives that we can get into at a later date, but know for now that each index is commonly used in this product depending on the lender chosen.
The Margin for these loans is determined by several factors including credit rating, the processing style of the loan – full doc, stated income, no doc, etc., the LTV (loan to value = how much of your home is financed as a % of it’s total overall value as determined by an appraiser), etc.
After analyzing Tom and Julie’s scenario above it becomes clear that there are certain individuals who may clearly benefit from the pay option mortgage loan when utilized in a responsible manner. Hopefully at this point, some of the distinct advantages and disadvantages to the payment option mortgage program have become apparent.
There are certain scenarios when the payment option mortgage becomes an invaluable tool for certain borrowers. Typically these programs work well for people that share some of the following characteristics:
-Those that have fluctuating incomes/cash flow such as:
-Self employed
-School teachers
-Seasonal workers
-Salespeople
-Those that have a significant amount of equity in their homes.
-Those that need “short term” payment relief due to the unexpected.
-Those who would like to pay off credit card/consumer debt.
-Those that are newly self employed and anticipating that their income will continue to rise.
-Real estate investors who want to have the option to minimize their payments if necessary.
-Those who are expecting a big job promotion or career advancement in the near future.
-Those who are expecting a family inheritance.
-Those that are looking to relocate/move within a short period of time.
-Those that live in an area with rapidly escalating property values.
-Those who wish to divert cash flow into interest earning investment vehicles as part of their financial planning strategy.
-Those who value maximum mortgage payment flexibility on a month to month basis.
Just as there is no “one size fits all” mortgage program or “perfect” loan for every single borrower, there is also no perfect payment option mortgage program for every borrower as well.
Furthermore, if the borrower’s sole intention is to pay off their loan as quickly as possible then that person may likely benefit more from a traditional 10 or 15 year fixed rate mortgage.
Unless a borrower wants or needs to have maximum payment flexibility available to them on a month to month basis and sees the “opportunity” value presented to them in doing so – they would most likely be better served by a traditional fixed rate or adjustable rate mortgage.
It is very important to note that there are many different variations of this mortgage program that do not necessarily mirror Tom and Julie’s scenario listed above. For example, there are variations that offer a “fixed” pay rate for a pre-determined period of time. In addition, the “fully indexed” rate will depend upon the corresponding index that the particular loan program is tied to. Some indexes are known and revered for their stability, while other indexes tend to fluctuate with greater frequency. The Index is a matter of personal preference and is chosen based upon many different factors.
Also of importance to note is that most payment option home loans “cap” the “minimum payment” option at 110% or 115% of the original loan amount thus reducing any risk that the borrower would wind up owing more than their property is worth. (also known as being “upside down” on a mortgage) Couple this with the fact that most lenders will not lend above 80-90% of the appraised value for the payment option loan and it becomes obvious that risk of owing more than the property is worth is greatly minimized.
We hope that the examples listed above were able to shed light on the mystery that seems to surround the payment option mortgage.
As with any large financing decision, it is critical to understand the mechanics that will ultimately dictate one’s monthly payments and financial future.
There is no doubt that it takes a little bit of time and effort to understand how this loan program works. If someone does not wish to take the time to understand how the payment option mortgage program works or cannot grasp how the payment option mortgage program works after taking time to try to understand it – then chances are good that it may not be the right mortgage program for them.
At the same time, if anyone were to tell a borrower that the payment option loan program is the only loan program that is right for them without taking the necessary time to understand and assess their financial background, objectives, goals and overall situation – they’d be much better served to seek out the assistance of someone who is interested in spending the necessary time with them to do so.
When utilized properly and in a responsible manner, the payment option mortgage program can be an excellent financial tool. One that offers a very unique set of benefits not found with any other loan program designed to help a homeowner manage their finances. That being said, it is absolutely critical that the borrower understand all aspects of the payment option mortgage loan prior to making a decision about what mortgage loan is truly “best” for them.
If you have additional questions about the payment option mortgage program, please click here: info@ultra123.com
***Please note that this program may no longer be available***
