Negatively Amortized Loans

There is not a clear understanding of the advantages and disadvantages of negatively amortized loans amongst consumers. A negatively amortized loan is not good or bad in itself––that depends on the consumers needs and preferences. It is important to understand the advantages and disadvantages of these loans––prior to judging them.

Most negatively amortized loans are based on the 11th district Cost of Funds Index (COFI). This index is the average cost of money to the San Francisco Federal Reserve, which is in the 11th district out of a total of 12 districts in the U.S.

The money for most 11th district loans comes from deposits made by customers. The Savings & Loans which make the majority of these loans like to match the interest rate on the loan to the interest rate they have to pay to their customers. So the loan interest rate is computed as follows :

Note rate=COFI + margin

where the margin is a fixed number (typically 2%-3%) & represents the S&L's profit margin. The interest rate on these loans have an initial teaser rate of 3-6 months, after which time the interest rate on these loans adjust monthly. Most loans have a lifetime interest-rate cap, which is the maximum the interest rate can go to. The lifetime cap is the actual maximum interest rate.

Some people have a misconception that the maximum interest rate can go higher than the lifecap, however this is not true.

The reason why the interest rate adjusts monthly is because the interest rate on S&L's depositor rates also adjust monthly. In addition, there are no monthly or annual caps on the interest rate. This is because there are no caps on the checking, savings, CD & money market accounts that the money is coming from. Even though there are no interest-rate caps a quick look at the history of the COFI will show that it normally changes less than 2% in a year.

Because this loan has no interest caps, the consumer protection agencies require the loan to have payment caps––they require that the minimum payment not increase more the 7.5% per year. So if the minimum payment in the first year was $1,000 then the minimum payment in the second year can be at most $1,075.

Since the minimum payment has caps and the interest rate has no caps, this can cause the loan to become negative––i.e. if the interest rate increases and the minimum payment does not increase sufficiently then the payment does not cover the interest payment causing the loan balance to increase. However, the customer can always pay a fully amortizing payment based on the current interest rate to keep the loan non-negative. This fully amortizing payment is exactly the same payment that would be made in the case of a non-negative loan at the same interest rate.

Example : 11 the district adj. 



Start rate = 3.95% for 3 months. 



Margin = 2.5%, Lifecap = 10.95. 



Current COFI value = 3.7%. (mid 1994 - value in mid 1995 is 5.1%)



Loan amount = $200,000







Start payment@ 3.95% = $949.55. 



In the fourth month the interest rate becomes 6.2% (3.7% + 2.5%) and



the payment should be $1225.55. However, the minimum payment remains at



$949.55 & you may pay only $949.55. This payment is so low that is does 



not cover the interest payment & thus causes the principal balance to increase.







In the second year the minimum payment is 949.55 * 1.075 = $1020.77.

In summary

The main disadvantage of a negatively amortized loan is that you can lose equity in your property if you make the minimum payment. Also, the interest rate adjusts monthly so that if rates do increase, your rate would change immediately. This loan can be a bad choice if you want to build equity in your property but do not have the discipline to make more than the minimum payment.

The advantages of this type of loan are: low payments, payment flexibility––i.e. make high or low payments depending on your needs and easier qualifying. Loans are more flexible since they are made by S&Ls. This loan can be good choice for first time homebuyers buying more they can afford and for self-employed borrowers whose incomes may vary month to month. It also be a good loan for rental properties because the payment flexibility can be used to avoid negative cash flow.