Several people on the SDCIA message board and off the board asked me to explain the Negative Amortization loans and how they work. The subject can seem confusing and scary, however, in reality it is not. Sorry it took me some time to do it, times are busy for many of us in this business right now. But here it is. This short write-up is for your initial information only, it’s not intended to provide you with all exhaustive answers, leave some for your CPAs, CFPs, CHPs (oops, that’s Ca Highway Patrol), and other advisers.
1) In a NegAm Loan you have a "Loan Rate" and a "Note Rate". Let's say your Loan rate is 2.95% (this is one of the programs that we offer), which means that for the next three to five years this will be your loan rate. Your ACTUAL Note rate is calculated by adding your margin locked in at the time of funding the mortgage (let's say 2.75%) to one of the indexes, such as LIBOR, MTA, COFI, CODI, etc. Indexes fluctuate, margins stay the same for the life of the loan. As an example, if your loan is priced today with COFI index, your NOTE rate would be at around 5.5%, and if you CHOSE to make fully amortized payments on your loan, it would be equivalent to having an adjustable loan at 5.5%. Are you with me so far? Good, let's move on.
2) As you can see above, there is about 2.5% difference between your minimum required payment on the loan (2.95%) and the Interest-Only payment on a 30-year fully amortized loan (5.5%, if the rate stayed the same throughout the life of the loan). This 2.5% difference (roughly) will be added to your loan principle every month and every year, IF YOU CHOOSE TO PAY NEG AM option (more on this later). The reason why the NegAm is so popular, especially in California, is that this 2.5% increase in your principle is even lower than the average inflation, let alone the average appreciation of the property values anywhere in the US! Let's say your property appreciated by 10% per year, your property is worth 200,000 and your loan is 150,000. If you chose to make the minimum payments at 2.95%, you added roughly $3,750 to your loan principle ($150,000 x (5.5% – 2.95%)) You just PAID $3,750 for an opportunity to MAKE $20,000, plus you put this $3,750 in your own POCKET in CASH now, rather then give it to the bank. Doesn’t it sound like a GREAT DEAL! You want to maximize your cash even more? Take this cash and invest it in the stock market now, this way you’ll diversify your portfolio and hedge against potential hiccups in the real estate market.
3) I said earlier "If you choose to pay NegAm...", here is why. Normally, on your statement you have four options:
Any months you can choose any of these options, which makes the loan extremely flexible. Again, the NegAm is just one OPTION, what option you take is your choice, but I don’t know of any other loan out there that provides you with so many choices! If you are afraid of NegAm, I also write Interest Only loans that, again, lower your monthly payments, or a short-term fixed rates (3-year or 5-year fixed) that lower your interest rate by 1% to 1.5% when compared to same day pricing on 30-year loans. Just don’t ask for a 30-year loan if you are planning to own the property for 5 years or less.
4) The reason why investors love this type of a loan is because when you sell your income property, chances are you'll go through a 1031 exchange, where you can't take out a penny of your equity without being taxed on it. With NegAms you are effectively taking the cash out of the property every single month! Again, use this perk wisely, don’t do it because you’ll have more money to go gambling or because you need more beer money, put it to work: invest it into additional real estate, notes or stock market. (Discuss your options with your CPA and your investment broker)
5) Here is the question that comes up when I start working with the clients who are new to the investment game: Should I try to pay down the mortgage on an income property as quickly as possible? The answer is NOOOOOOOOOOO!!!!! Actually, only if you are planning to hold this property for the rest of your life, and even then, I would still say NOO!! You need to look at the income property loan as a BUSINESS LOAN!!! Its primary two purposes and the only two purposes are (a) opportunity and (b) cash flow. The loan on you income property has to provide you with an opportunity to leverage your money and to obtain a money-making asset, and, secondly, the loan on your property needs to give you CASH FLOW. I personally do not believe in income properties with negative cash flow, never, never, never! Well, I'll take it back: the only time I'd say it's OK is when you have, let's say, a fourplex and you live in one of the units and rent the other three, your cash flow is negative $400 per months, however, if you moved out and rented out your unit, it would be positive $600. It's OK because you reduced your mortgage that you'd pay if you lived in a single family dwelling, and you estimate your positive cash flow on the rental of the whole property
These were some of my thoughts on the Negative Amortization type of real estate loans. The subject is much bigger than this, however, it should give you some initial tools for smart investing. Feel free to contact me for more clarification, I’ll be more than happy to share the knowledge (both ways) especially when you want me to help your with your mortgage or real estate deals (that’s how I make money, you know).
Happy Investing!
Alex Lisnevsky
Mercury Capital Group Inc.
(760) 757-5070