Loan Recasts

(Option Arms, Neg-Ams, Pick-a-Pays, & Deferred Interest Loans)

Q.  In your May issue, the one about the sub-prime fiasco, you referred to teaser rate loans and mentioned that if a borrower were to make only the minimum payment they would end up with their payment more than doubling in time.  We have one of those so-called option ARM loans and I’m still not clear why that would happen.  Could you provide some real world numbers by way of explanation?  Our loan amount when we took it out was $400,000 and we’ve had it about 33 months.  Our minimum payment was based on a rate of 1% but our loan agreement says our interest rate is 7.5%.  I’m confused by this, is our rate 1% or 7.5%?  Our mortgage note said that the loan would recast after 5 years or when our balance got to 115% of the original amount.

A.  Your loan goes by a variety of names:  option ARMS, Pick-A-Pays, neg-ams, and deferred interest loans.  The problem is not with the loans, per se, but with borrowers not fully understanding what they signed up for.  Not to mince words, it sounds as though you’re one of these borrowers. These loans were popular because they were marketed to buyers based on low (minimum) payments, so it is not surprising that many, if not most, buyers chose the lowest payment option.  The thing that is most often the source of borrowers’ undoing is that the minimum payment does not cover the interest on the principal so the amount of unpaid interest (or deferred interest) is added to the loan balance (principal).  When the loan balance exceeds 110% to 125% (depending on the lender and loan program) of the original loan balance, the loan “recasts” such that the new loan balance will be paid off within the remaining years of the loan term in amortized payments.  Then, the minimum and interest only “options” are no longer available.  

An option ARM loan of $400,000 @ 7.5%, the true note rate (or contract rate), would have a minimum monthly payment of $1286 (the minimum payment is arrived at by using an amortized rate of 1%--this does not mean any of the payment is going toward principal reduction, it is only a way of calculating the minimum payment).  The interest only payment would be $2500 and the fully amortized payment on a 30 year term would be $2796.  In your case since the recast limit is 115% of the original loan amount, then, when your loan balance reaches $460,000, it will recast.  If you have been making only the minimum payment, your negative amortization is ($2796 – 1286) = $1510 is added monthly to the loan balance and will hit the $460,000 recast point in your 39th month (460,000/ 1,510).  This will leave only 321 months remaining in which to pay off the loan (30 years x 12 months = 360-39 = 321).  After the recast, minimum and interest only options no longer exist and the amortized payment will be 258% higher than the $1286 you have been accustomed to paying and the new payment will be $3324.  By my calculations your new loan balance is (33 x 1510 = 49,830 + 400,000) = 449,830.  Since you have approximately 27 months left on your mortgage before it will recast, providing your loan balance does not hit $460,000 first, I would begin increasing my minimum mortgage payments in the neighborhood of $838 so as to get the most mileage out of the remaining 27 months of your mortgage before it recasts at the 5 year mark.  I arrived at this number by subtracting $449,830 from $460,000 leaving 10,170 then dividing this by the 27 months left on a five year term (5 x 12 =60 -33 = 27) and dividing this gives 10,170/27 = 376, then, $2500 (interest only payment) - 376 = $2124.  Or, 1286 + 838 = $2124.

Incidentally, you didn’t mention if your option ARM loan was a traditional Option ARM (where the annual payments increase 7.5% per annum) or a 5 year hybrid (where the payments remain fixed for 5 years, providing the recast limit is not reached so I assumed the latter.  If you had the former, you would have slightly more cushion at $13,122 before you reached the $60,000 recast point and you would only have to increase your payment to $728.  In case that’s the situation, here’s the math $13,122/27 = 486 amount of negative amortization that could be added monthly and still not trigger the recast. $2500 (amount of interest only payment) minus the $486 = $2014.

You didn’t ask it, but sometime prior to the 60th month, you should arrange to refinance and it might not even be a bad idea to choose an Option ARM loan again, if real estate prices are rising faster than your loan is negatively amortizing and if they’re still available.  Just be sure you know what you’re getting yourself into.

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