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WWWThe 1% Mortgage
Option ARM, Pick-a-Payment, FlexPay, MTA

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The One Percent Mortgage-  Is it right for you?


The 1% Mortgage - Be Careful What You Wish For!

Mortgage bankers and brokers have been advertising the 1% or 1.25% mortgage as if it was a gift from above. Its also called an Option ARM, Pick-a-Payment, FlexPay, MTA...among others.



 It happens to be an interesting loan because with each monthly statement you are given the option of any one of 4 different payments...you can pay just the monthly interest, you may choose between a 15 year or a 30 year amortizing payment and you are given a 4th option, a payment that is less than the interest only payment. If you choose this option, you create deferred interest...also called negative amortization.

Isn't negative amortization bad?

It completely depends on the situation. Fact is, negative amortization can be a useful tool - if it's used properly. It presents an opportunity to defer part of your payment to some time in the future. The problem is that some people will "access" the negative amortization without regard to paying it back. And at some point, it will need to be paid back. Not only will the deferred interest need to be paid, but interest is charged on the deferred interest. Interest on interest, so to speak.

When a borrower relies on the lowest payment option just to keep up, well, that's just bad financial planning. Good financial planning would be if you used the lower monthly payment in order to pay off other debts - especially if those other debts carry higher interest rates and are non tax-deductible. Here's my rule of thumb. If you can only handle making an interest only or negative amortization payment, then stay away from the loan. If you are using it as part of a total financial planning effort, then the loan may make some sense. But please, do not let some rookie loan officer talk you into taking the loan because home values are appreciating or because you can refinance you in a year or two. That loan officer is only looking out for themselves... not you.

At 1%, the payment should be super low, right?

Well yes, it is. But you must understand that 1% is the interest rate only for the first month. After that, the 1% is actually a payment rate - not the actual interest rate.

What's the difference?

Here's how it works. The loan offers a payment for the first year of the loan amount at 1% amortized over over 30 years. That becomes the minimum monthly payment for the 1st year. But after the 1st month, the actual interest rate jumps up - to a rate that is the sum of an index (1 year treasury bill, LIBOR, 12 months average of the 1 year treasury bill, etc), PLUS, a margin. I'm sure everyone realizes that a 1% fixed rate mortgage doesn't exist. And they would be correct. So advertising a 1% rate is definitely misleading. You're allowed to make the 1% rate payment, but that payment will be much less than the payment required to cover your principle & interest. This is how negative amortization occurs.

So why are we seeing so many advertisements for this 1% mortgage?

There are a couple of reasons. I may invoke some anger and criticism from mortgage brokers and bankers but here's the truth of the matter. The Option ARM is an easy sell. It provides for a super low payment for the amount being borrowed. It pays brokers and bankers very well - since some risk is transferred to the borrower, the lender has an extra level of protection when interest rates rise. So these loans can be more profitable versus a fixed rate and lenders can compensate bankers and brokers for this transfer of risk.

Also, as stated earlier, these loans come with a margin. A margin is the amount added to an index which is then used to compute the borrowers future interest rates. Most borrowers know nothing of margins and brokers receive compensation based on the margin - the higher the margin, the higher the compensation. Do you see how a loan officer might feel free to make as much as he can on a mortgage? Sure it does. Also, it's new. And people love new things. So the loan officer has a product with a bunch of bells and whistles, that's easy to sell because of the low "payment rate", they can make a lot of money on the loan and most borrowers don't know enough about the loan to shop it. That being said, the loan does allow you to purchase more home for the money.


First, lenders will usually offer their adjustable at rates that are lower rate than their fixed rates. You're accepting the risk of rising interest rates. Why would you take an adjustable if you're not getting something in return? Secondly, you may pay just the interest on the loan...no principle. Those two features make for a pretty low payment. To give you an idea.....say you borrow $300,000 at 6.5% over 30 years...the regular amortizing payment is $1896.20. An interest only payment at 6% is only $1,500.. With housing prices being what they are, you can see why these types of loan are popular.

But if you only pay the interest on the loan, you're no getting anywhere, right?

That's true. Unfortunately, brokers and lenders have convinced much of the American public that paying down principle is not so important. Equity will come from home appreciation rather than the pay down of principle, they say. And that's an easy sell when your home is appreciating 10% or more each year. But real estate appreciation is not guaranteed. We have had a number of prolonged periods in which real estate values remained stagnant; some periods even saw real estate go down in value. I would say that for the foreseeable future, we will not see much price appreciation. I think it's safe to predict that we will even see depreciation in certain parts of the country. In most areas of the country we've had tremendous appreciation over the past 5 years. In markets, when values increase too rapidly, a correction is bound to occur. We only have to look back to the internet bubble to see a perfect example.

Another factor is that people do tend to refinance more often these days. An average mortgage in America today is held for less than 5 years. Paying down the principle becomes less important if you know that you'll only be in the loan for 5 years. But a loan is a loan is a loan. At some point, someone has to pay it off.

Who might be a good candidate for this type of loan?

There are some people that this loan would benefit. If you are living below your means, can afford a higher payment, and just want to minimize your outlay until you sell the home at some point in the future, then this loan may work for you. The payment rate is much lower than what a traditional loan payment would be. You're buying time, but sometimes, buying time is what is needed. Also, people with income that may vary from month to month, this loan may work out well. You can pay the 15 or 30 year amortizing payment during good months, pay only interest or the negative amortization payment during leaner months.

This loan also works well for people that watch their investments very closely. Why pay down principle on a 6% interest rate when you can invest that same money at 7%, 8%. or more?

Are there other features of the loan we should be aware of?

The main thing that can get people in trouble with this loan - and the one thing that many loan officers fail to mention - is that most lenders that offer the loan do so with a 5 year recast. This means that after 5 years, the loan will be re-amortized to sufficiently pay down the loan in 25 years. For borrowers that are paying only the minimum payment, this will come as quite a shock. The minimum monthly payment could potentially increase by as much as 55%. Many won't be able to handle such an increase. They'll be forced to sell their homes. I just hope for their sake, they'll have a healthy local real estate market to sell into. If not, they may be "upside down" on their home - meaning they owe more than the value. This can lead to foreclosure. And if there are too many foreclosures, that will hurt the real estate market even further. Banks don't want to own real estate. They will dump the properties just to get them off their books. What if you need to sell your home but your competition is a number of banks selling their properties at the same time. Could make for a real tough go.

Another thing is to make sure you get a lifetime cap of no greater than 9.95%. Some lenders may offer it with a higher cap than that but with a longer recast period. That makes for a tough choice. Personally, I would go for the lower lifetime cap. But I would be making higher payments than the minimum so the recast period would be of less concern.

In short - please do NOT get into this loan because it offers such a low monthly payment. you can get badly hurt if real estate values drop in your part of the country.

By Ron Borg


Copyright 2006, Ron Borg & AskRonBorg.com All rights reserved. Reproduction of this article is hereby granted provided that all content & sig file is kept 100% intact.

By accepting and reading this, you agree to all of the following: This newsletter, article or email and all the opinions expressed herein, are for personal entertainment & informational purposes only, and in no way should be considered legal advice.

As with most transactions in real estate and financing, we highly recommend using the services of an attorney. You, and you alone, are solely responsible for the use of the ideas, concepts, opinions and content and hold TRon Borg, AskRonBorg.com and all members and affiliates harmless in any event or claim.

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