 Don't
refinance into negative amortization loan
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 Dear
Dr. Don,
My friend's mortgage broker is talking him into refinancing his
current 5 percent ARM into a negative amortization mortgage. The
sales pitch thrown to him is that if he pays the minimum amount
due every month to the bank, and he puts the difference in what
he is currently paying into an interest-bearing account (high rate
money market, for example), he would have his house paid off in
10 years based on the power of compound interest on his money market accounts.
For example, he currently pays $2,000 a month for his mortgage. The new
negative amortization mortgage would call for a $650 payment. He would then take
the difference of those two amounts and put it into a money market account. I
have not crunched the numbers, but is this sales pitch legitimate?
-- Todd
Tilt
 Dear
Todd,
With negative amortization the monthly loan payment doesn't have
to be large enough to cover the monthly interest expense. When the
loan payment doesn't cover the interest expense, the outstanding
loan balance increases by the shortage. The loans are typically
structured so that after a while the mortgage payment increases
to reflect the higher outstanding loan balance.
For the power of compound interest to allow him to pay off the
loan faster, the after-tax interest rate on his investments has
to be greater than the after-tax cost of his mortgage. Money
market rates are very attractive right now, and he could earn over
5 percent pretax in a money market account or a money market mutual
fund, but it's likely that the after-tax cost of his mortgage is
still greater than the after-tax return on his money market investments.
You can't ignore
the tax deductibility of mortgage interest expense and the taxes due on the investment
earnings. Including the relevant tax impacts would make an even stronger
argument for not going the interest-only route. Negative amortization on
the interest-only loan wouldn't help the situation because you are increasing
the interest due on the mortgage. Plus there is the question of whether your
friend would have the financial discipline to invest that extra money every month.
And what happens if interest rates go down?
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the Experts" page and select one of these topics: "financing
a home," "saving & investing" or "money."
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