Category: Financial Services



I am sure that many of you have now heard the perils of Negative Amortization Loans.  I have done a little research and found that Negative Amortization Loans are still being offered by US mortgage companies today.   One primary rule of business is, “If no one is willing to buy a product, then no company bothers to sell the product.”  What does this mean?  It means that if companies are still offering Negative Amortization Loans, there are still consumers in the US who are buying these loans.  Therefore I felt it was important to talk about how Negative Amortization loans work and how to realize that you are in fact purchasing this type of loan.

What is a Negative Amortization Loan:

Let’s start with a few definitions…

Principal – “The amount borrowed or the amount still owed on a loan.” (investopedia.com)

Amortization – “In the lending, amortization is the process of paying off a loan. The loan balance gradually decreases as you make interest and principal payments on the loan.” (about.com)

Interest Rate – “A rate which is charged or paid for the use of money.  An interest rate is often express as an annual percentage of the principal.” (investorwords.com)

Payment Option – The monthly payment you chose to make on negative Amortization Loan.  Typically this is based on a percent of the principal (like 1% of the principal).  The payment option does not affect the interest rate of the loan.

Example: Principal = $250,000, Interest Rate = 5%, Payment Option: 1%

In a typical 30 year Fixed Rate Mortgage, the loan has a 30 year amortization period.  If you bought a $250,000 home, the original principal would be $250,000.  The loan is amortized over 30 years, which means at the end of the 30 years you will have paid off the original $250,000 and your house will be paid off (assuming you did not refinance).  If you originally owed the bank $250,000, after 1 year of payments you would still owe $246,311.59.

In comparison, a Negative Amortization loan does not pay off the original $250,000 that you borrowed from the bank.  Instead the principal balance increases every month.  In this example, you owe 5% in interest charges every year, but you are only making 1% interest payments.  Therefore at the end of 1 year you would owe the bank $252,917.06.  Notice, this is $2,917.06 more than the original loan.

Why is a Negative Amortization Loan the easiest way to end up in foreclosure?

I have just showed you that the balance owed on these loans increases every month.  Unless your house value consistently increases, you eventually owe more to the bank than your house is worth.  If you owe more than your house is worth, you cannot refinance the loan or sell the house.   This means, if you cannot make the loan payments, typically, your only option is to foreclose.

Many people do not understand how Negative Amortization Loans work, and therefore do not understand how they could end up unable to make the payments.  It is important to note that the interest rate on Negative Amortization loans is not fixed.  Since the interest rate is adjustable, you could start out with a 5% interest rate and end up with an 8% interest rate a year later.  In addition, the minimum payment on a Negative Amortization Loan also adjusts throughout time.  Although many borrowers start out paying 1%, the payments eventually change to interest only or principal payments.  When this happens the monthly payment on your loan can double.

Let’s think about our earlier example.  Originally you were making a 1% payment on a 5% loan.  Your monthly payment would have been $804.10.  Now let’s assume that your interest rate increases to 8% and you are now forced to pay at least the interest payment.  Your new payment is $1,666.67.  If you cannot afford to pay $1666.67 and you now owe more than the house is worth, the bank forecloses on your home.

If Negative Amortization Loans are so risky, why do people choose them?

If you have been following this blog, you probably know that I used to be a Personal Banker.  At the time I lived in Stockton, CA.  Stockton was one of the cities that were hit hardest by sub-prime lending.  Although the bank I worked for did not offer Negative Amortization Loans, I know many people who had Negative Amortization Loans on their house.  Almost all of them were forced into foreclosure.

 The most common reason a consumer chooses a Negative Amortization Loan is because they do not realize what they are getting into.  Many people are totally unaware that the principal balance they owe to the mortgage company is increasing every month.  They become aware of the issue when they go into an unrelated bank and try to make a monthly mortgage payment and the teller or banker notices an extremely low payment amount for the size of the loan.

How could someone chose a Negative Amortization loan without realizing how it works?

Risky products are never marketed as something that may kill you.  Think of prescription diet pills.  They are marketed as helping people drop 50 lbs in 2 months, not as something that has a 30% chance of giving you a heart arrhythmia.  Negative amortization loans are sold in the same fashion.  Companies talk about low monthly payments so you can afford a home and ability to refinance later when the value of the home increases or you start making more money.

Warning signs of a Negative Amortization Loan

1. There are many names for these loans.  Look out if your loan is called:

  • Negative Amortization
  • Neg Am
  • 1% Loans
  • Deferred Interest Payment Loans
  • Pick a Payment
  • Pay Option ARM
  • Or if your loan has a “Minim Payment Option

2. Your realtor or mortgage broker ever says:

  • “Don’t worry you can refinance it later…”
  • “The loan has a 1% payment.”  Home loans in the US never have 1% interest rates.  If someone ever tells you 1%, they are either putting you in a Negative Amortization Loan or the interest rate on the loan will increase dramatically after the first year or two.
  • “Sign here,” without explaining in detail each page that you are about to sign

3. The monthly payment is much lower than any other quote you have gotten.  Usually a couple hundred dollars or more lower.

4. You did not think you could afford this house until you talked to your realtor or mortgage broker.

5. You have a bad or ‘not so great’ credit score and someone is offering you really low interest on a mortgage.

What can you do if you are worried someone might be putting you in a Negative Amortization Loan, but you are not sure?

Do not sign anything.

Before you sign, bring a copy of the documents to another bank.  Ask the banker to look at the closing documents and tell you what type of loan it is.  It is essential that the bank has no relation to your mortgage broker or your realtor.

If you are uncomfortable bringing the documents to another bank, have a lawyer look at them.

If nothing else, chose a friend or family member who is well versed in finances and have them look at the documents.

Pay special attention to the document page that talks about the interest rate.  Make sure there is only one interest rate listed, the page does not mention “ARM,” “adjustable rate,” or “minim payment changes.” 

Have you had experience with a Negative Amortization Loan?  Are looking for help to get out you Negative Amortization Loan?  Do you have other related questions?

 I would love to hear from you.  Please feel free to leave a comment.

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The abilty pay a fee in order to use money you do not have, has its purpose in life.  Mainly when a bill is due, you know you do not have the cash to pay it, and the company will not take a credit card payment.  However, nobody enjoys unnexpected overdraft fees (ie: you did not realize that you had insufficient funds to cover your purchase).  Yet there is a large portion of the US population that fights a constant battle with keeping their account balances in check. 

Shortly after starting work at as a banker, I remember telling my boss that I had never balanced a checkbook in my life.  He looked at me like he was about to have a heart attack before I remedied the conversation.  However, the truth is that I had been using a checking account for 6+ years and had only overdrafted an account once in my life.  The one overdraft I had incurred was when I had been out of the country and unable to check my balance for 6 months.

Since that time, I have encountered many people who have not learned the tricks of account maintenance.  Some of this is due to lack of financial budgeting education.  Moreover, banking has changed in the last 50 years.  Many people who currently range from teenagers to early 30’s do not use checks as their primary method of banking.  In general, people who rely on ATM’s, debit, and credit do not balance a check books.

So if you or someone you know has moved from the realm of occasional overdraft to consistent overdrafting, here are a few ways to help get the situation under control.

1) Opt Out of Overdrafting

This is an option that had been unavailable until recently.  Although the option is not available at all banks,  it is a great option.  By opting out of overdrafting you will never be charged an overdraft fee.  You still need to budget your money to ensure that you do not run out. 

However, buy opting out of overdrafts you cannot spend money that you do not have.  This means if you run out of money in your checking account, your debit card will be declined, you cannot take out cash, and your checks will bounce.  When checks bounce, you are usually charged a fee by the company that tried to cash your check.

2) Opt In to Overdraft Coverage

Overdraft coverage typically links another account to your checking account.  Most of the time, you still incur a fee any time that this money is transferred into your checking account.  The fees tend to be much lower than overdraft fees.  The most common types of overdraft coverage links a savings account or credit card to your checking account.  For this coverage to work, you need to have money in the savings account or available credit on the credit card when you overdraft your checking account.  Since overdraft coverage varies between banks, it is important to check with your bank concerning the particular rules of this coverage.

Be sure to ask your banker:

  • How much am I charged for a transfer fee when I overdraft the account?
  • Will I be charged a cash advance fee in addition to the transfer fee? (credit card coverage)
  • Are there any other fees?
  • Will I be charged per overdraft or per day of overdrafting?  For example: a person could overdraft on 5 purchases in 1 day.  That could either count as 5 overdraft coverage transfers (per transaction) or 1 overdraft transfer (per day)
  • How much money is transferred from the linked account?  Often banks transfer a block of money (ex: $25, $50, $75, etc) or they transfer a minimum amount of money (ex: $100+).  In order for the overdraft coverage to work, you need to have the right amount of money in your account.  For example, if you bank does transfers in block of $25 and you overdraft your account by $3, the bank will still transfer $25 in to your checking account.  If you do not have $25 available, the transfer will not occur.

3) Utilize Mobile, text, and Online Banking

I am a big fan of online banking and have been using it for years.  Online banking is great for people who do not balance checkbooks.  The online banking system keeps track of all purchases you have made on your debit card, bill payments that you have done online, and any cash that you have taken out of the ATM.  It also lets you know if you have pending charges that will be debited from your account within the next few days.

Text banking is a simplified version of online banking through your cell phone.  You do not need a smart phone (iPhone, Android, Blackberry) to use text banking.  Text banking is great for checking your balance while you are out making purchases.  Before you swipe your debit card you can quickly check your balance to ensure that you have enough money in your account.

Mobile banking is available on smart phones (iPhone, Android, Blackberry).  Mobile banking let you check your balances, much like text banking.  Depending on your bank, mobile banking can also have much more sophisticated features, like checking your account statements, payments, and making deposits with your phone.

Note: Online, text, and mobile banking do not show outstanding checks.  If you have written recently written a check, that has not yet been deposited or cleared your account, your balance will not include that check.

4) Set Account Alerts

Account alerts are typical set up through online banking.  If you would like to set up account alerts and are unsure how to do it, stop by your local banking branch and they will be happy to show you.  Most online banking sites also have instructions once you have signed into your online banking account.  Account alerts can typically be sent to you email or your cell phone.

 

  •  Balance Alerts:  These are the most helpful alerts to avoid overdrafting your account.  You decide on a specific amount of money that you consider a low balance (let’s say $100).  Once the alert is set up, your bank will email, text, or phone email you warning you when your account has dipped to or below $100.  It is best to set up the alerts for a media that you check often.  If you check your email 10 times a day, then email alerts would be a great option.  However if you hardly check your email, text or cell phone emails may be a better option.
  • Deposit Alerts: These alerts let you know when a deposit has been made to your account.  By doing this you do not have to worry if the bank has received your check or not.  You avoid spending more money until you are sure that your check has cleared.
  • Spending Alerts: These can either be set up for the size of individual purchases (ex: $500 at any given store) or set up as daily alerts (ex: $500 in total spending on any given day).  These alerts help you keep track of days that you may have over spent.
  • Bill Pay Alerts:  These alerts let you know when a payment has cleared your account.  Typically these will cover either checks that you have written or electronic bill payments you have made.

NOTE:  The types of alerts that are available vary depending on your bank.  These alerts are also a great system for warning consumers of fraud on their accounts because it alerts you of unusual spending.

5) Switch to Cash Near the End of Your Pay Period

This is a great method for people who are not fans of technology and do not balance a check book.  Overdrafts tend to occur near the end of a person’s pay period (ie: right before you get your next pay check).  This requires a plan.  Choose an amount of money that is sufficient, many people chose $100.  When you notice your account nearing the last $100, take all of the money left out in cash.  By taking the money out in cash you ensure that you will not overdraft your account by accident.  The money is in your wallet, you know exactly how much you have left until your next paycheck, and you can spend accordingly.

If you decide to use this method make sure to cover necessities first when you take the remainder money in cash.  Buy groceries, gas, or anything else you absolutely need before you spend the rest of the money.  You may still run out of money before your next paycheck, but if your necessities are covered it is not the end of the world.

6) Always Use the PIN Option on Your Debit Card

Debit cards always have 2 different options.  When you make a purchase with a debit card, you can enter your PIN or you can sign a receipt.  When you enter your PIN, the transaction is processed as a debit transaction.  When you sign a receipt, the transaction is processed as a credit transaction.  Debit (PIN) transactions are always debited from your account immediately.  Credit (sign a receipt) transactions are often debited from your account days later [depending on the bank.

I have seen article on avoiding overdraft fees that say to run everything as a credit transaction (sign a receipt).  These articles claim that it is better that you have a delay before charges are debited from your account.  This is the worst thing you can do if you tend to forget how much money you have spent and how much money you have left.  By having a delay between when you make the purchase and when the money is taken out of your account, you have to remember exactly how much money you spent until the purchase hits your account.  By using the PIN option on your debit card, you do not need to remember what you spent.  Instead you only need to continue to check your available balance.

7) Avoid Using Checks

Checks are the big unknown in your account balance.  Despite all of the technological advances in banking, there is no way around tracking your own check usage.  Therefore it may be better to avoid writing checks if you have problems remembering to track them.  There are a few different options that replace the use of checks.

  • Online Bill Pay: Depending on your bank, you can now pay most if not all of your bills online.  These payments are usually debited out of your account the same night or within a few days.  This shortens the amount of time you have to remember the transaction.
  • Cashier’s Checks: You can get a cashier’s check at any bank branch.  The teller debits the money out of your account and hands you a bank drafted check.  Since the money has been debited from your account immediately your account balance will reflect the check immediately.  It is important to keep the receipt for cashier’s checks.  Since the check clears your account immediately and not when the other person cashes the check, the receipt has the information you need in order to verify that the other person cashed the check.  Depending on your bank and account type there is often a cost for cashier’s checks.  Ask you banking representative what the cost is.
  • Automatic Bill Pay:  This can usually be set up for utilities, rent, mortgages, car payments, credit cards, etc.  You can either set up the payments through your bank or through the company you are making payments to.  If the payment is set up through the bank you can make changes to the amount, date of payment and other information with your bank.  If you set the payments up online you go back to online banking to make changes.  If the payments are set up through customer service with the bank, you make any changes with that same department.  Generally, all automatic payments set up with the bank will be debited from your checking account.  If you set up the payment through the company you are paying, any changes must be made with that same company.  When automatic payments are set up through the company, you have a choice between paying with your checking account, your debit card, or your credit card.  However, not all companies will offer you 3 different choices of how to pay your bill.  Often companies will give you 1 or 2 different payment options.  With automatic bill pay you can often chose what date the bill is paid on. 

NOTE: It is always best to set up automatic payments for the early part of your pay cycle.   This allows paid your necessary bills before you spend money on other items.  You can always choose to cut back on convenience items, like eating out.  However you cannot choose to cut back on paying your rent, utilities, gas for work and other necessities.

8) Create an Account Buffer System

This system takes some will power and mental training, but is one of the greatest ways to long-term change the way you deal with money.  It will probably take some time to get used to, so it is best to use in combination with other methods until you are used to it.  On the other hand, this is the major reason I never unknowingly overdraft my accounts.

In my personal life, I have always been somewhat paranoid about money.  I think it is a trait that I inherited from my father.  I have always assumed that $0 in my account is not just broke; it is a reason for panic.   Because of that thought process I have always had an amount of money that I think of as broke.  Throughout my life the specific amount of money has changes dramatically, depending on how much income, bills, and savings plans I had at any given time.  However I always have a number in my head that ranges from $20-$5,000.  That number is based on how much buffer money I need to cover an emergency.  If I have almost no income and almost no bills it could be $20 because the emergency is that I may need to get home if my ride bailed on me.  If I am saving up because there is a chance of unemployment, or one of the cars breaking down, the number could be $5000+ to cover the cost.

In this system you decide on a buffer amount that you would always keep in your account.  This number is dependent on the amount of money you would need in an emergency.  An emergency can be anything from you forgot to bring lunch to work to you need your utility bills double this month from a heat wave.  Pick a number that makes sense for your life.  Be careful though, to pick a realistic number.  If you tend to spend $100 when something goes wrong, do not pick $20 as your buffer money number. 

The trick to this system is to mentally convince yourself that the buffer number is equivalent to having $0 in your account.  Let’s use $100 again.  Assume that when you hit this balance it is the equivalent to having $0 in your account.  By mentally deciding that $100 means you are broke, you do not need to overdraft your account when a last minute unexpected expense pops up.  If you do drop below your magic number, it is important to get that buffer back into your account on your next pay check.

9) Use your Credit Card

This option works well for people who stay within their general budget, but do not track their daily spending.  By using your credit card instead of your debit card, you do not need to worry about overdrafting your account.  When the credit card bill is due you pay off the entire balance.  This works great when there is a necessary bill that is due before your check has come in.  For example, say that you need gas to get to work today, but your pay check does not come in until tomorrow.  You can put the purchase on your credit card and pay it off as soon as your check comes in.

NOTE: This is not a good method for people who tend to overspend in general.  If you are not good about keeping to a general budget, you will rack up debt on your credit card that you cannot easily payoff.

10) Use a Prepaid Card

Prepaid Cards always have some type of fee associated with their use.  Depending on the card, the fee can be per month, per purchase, or per time you load more money on the card.  It is important to understand the fees associated with a card before you start using it.  Prepaid cards can either be much cheaper than account overdrafts or much more expensive depending on how they charge fees and how you tend to use the card.  These cards can help people who like the convenience of using debit, but have problems tracking their spending.  Once the card is out of money, you cannot use it again until you add more money to it.  Therefore, you cannot overdraft a prepaid debit card.  These cards can either be purchased through your bank, online, or at drug stores and convenience stores.  The cards are reusable.  You can load money on to the card online, over the phone or in person depending on the card.

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Background on Microfinance

What is Microfinance:

Microfinance is a form of financial services that lends money to extremely low-income individuals, who typical do not have access to typical bank lending options.  The loan (microloan / microcredit) is generally used to start or expand a small business.  The recipients microloans are often fairly new entrepeneurs that have a 1-3 person business. 

What size are microfinance loans:

Typically microfinance loans are $100 or less.  This dollar amount varies by the geographic location of the recipient and the investment project.  I have seen loans that range up to $1,000 or $2,000.  This can be for two reasons.

  1. The investment is for a more established business
  2. This is a pooled investment with more than 1 loan recipient.  Often, microfinance projects will focus on a specific type of investor.  For example one project could be investing in small farmers in a specific region.  Therefore each individual farmer would receive a small loan, but the project would aim to help many farmers.

How is Microfinance different than donating to charity?

When a donor gives money to charity, administrative fees are taken from the donated money, in order to cover operating expenses.  The donated money that is left over is dispersed to recipients.  Recipients use the money and the process is complete.

When a person invests money in microfinance, administrative fees are still taken from the donated money, in order to cover operating expenses.  However the money that is dispersed to recipients is a loan.  Any recipient of microfinance, must pay back the money they were given.  In addition, recipients are almost always charged interest on the loan.  The payback is similar to any other type of loan (ie: credit card, car loan, home loan).  Generally the loans have a payback period of a couple years, however this varies depending on the project. 

click to enlarge "Why are Microfinance Interest Rates so High?" Adam Fish 7/5/10

On average, microloans charge 30% interest. (1)  This rate may seem extremely high.  It is comparable to the high-end of US credit card rates.  However, the alternatives to microloans warrant this type of interest.  Recipients of microloans would not be approved for a typical bank loan.  Without the ability to borrow from banks, potential recipients are left with few credit options.  Credit options that exist are extremely expensive.  Take the inhabitants of Dharavi, India as an example.  Low income inhabitants of this area will typically pay 600-1000% interest per year for credit (Professor Sridhar Balasubramanian, MBA 741, UNC Kenan-Flagler).  Moreover, the cost of making and servicing microloans tends to be high.  As you can see, in the graphic to the right, almost all of the interest rate charges are used to cover the costs of the loan.  By charging an interest rate, microlending groups can ensure that the original money used to finance the loan can be reused for future loans.

Why microlending is cool:

You may be thinking, “Why would I invest in a group that is going to charge recipients money, when I could just donate to a charity?”  Well microfinance is cool because if it is done right, the original money can help many more people than a charity donation would.  The microfinance model is set up to be self-sufficient.  Lets use the example of a $1000 contribution.  Assume that both charities and microfinance organizations have a 20% administration cost.  Also assume that each recipient must receive at least $100.  This means that 20% of the funds that get contributed, go towards paying costs of the organization.  Therefore, in either case, the original $1000 contribution becomes $800 of distributed funds.  In the case of charity, the $1000 donation has just improved the lives of recipients by $800.  In total the $100 has helped 8 people. 

click to enlarge (by: Diana Nicholson)

Across the board, microloans have a payback rate of 90%.  For example, if funds are distributed to 10 recipients, 9 of those recipients will pay back the loan.  However, because microloans are paid back, that same $1000 contribution becomes $2767 of distributed funds.  This is $1967 more than with charity.  Moreover instead of helping 8 people, 25 people have been helped.

click to enlarge (by: Diana Nicholson)

 

Now if that same microfinance group charges 30% interest, most of the money that is lost in administrative fees and loans that did not get paid back, is recouped by the interest.  Therefore, the same $1000 original contribution becomes $10,994 in distributed funds and helps 115 people.

click to enlarge (by: Diana Nicholson



Why I think Microplace is a great idea:

There are many great microfinance companies that individuals can contribute to.  Some of the ones I have heard of are: Kiva, Accion, and Micro.  However, I think the idea behind Microplace is great because the investment you make there pays interest to the investor.  For example, if you invest $1000 in Microplace, you will earn 1%-3% interst per year on the investment.  So, assuming the loan is repaid, at the end of the year an investor would have made $10-$30 in interest.  This money, in addition to the repaid principle, can either be cashed out or reinvested in another loan.Why is that so great?

  1. If you chose to reinvest, you can help more people than with other organizations, without adding more of your personal money.
  2. If you chose to cash-out the investment, you made money.
  3. Although man kind can be giving in nature, man kind tends to be more giving when the personal benefit of giving is greater (ie: make a little interest on the side, or have the ability to keep investing larger amounts of money without having to decrease one’s personal budget).
  4. This is a social responsible investment.  Even if someone wants to earn a little interest on their savings, they can do so while helping the world at large.  This opens up the opportunity of helping, to individuals who are counting on the personal savings for future need (ie: people who would probably not donate the same money to a charity or donate it to a normal microfinance cause).

In essence, by paying investors a small amount of interest, Microplace increases the amount any individual investor may be willing to contribute and expands the pool of potential investors.  Both of these lead to a world of microfinance that can grow faster and help more people.In addtion, Microplace still allows investors to choose what type of investment they would like to make.  The site includes options on social cause contributed to, rate of interest, repayment schedule, diversification of fund, and geographic region.  Investments can be as small as $20.

How does Microplace compare to other investments?

Microplace

 Rates: 1%-3%

Terms: 2 months – 4 years

NOT FDIC ENSURED (you can lose your money)

 

CD

Rates: .25%-1.3%

Terms: 7 days – 4+ years

FDIC ENSURED (you are guaranteed to get your money)

 

Stock

Rates: Depends heavily on your investment choices.  Average 11.9%, however has been lower during the crash.

Terms: No set term.  Generally advised expect at least a 5 year investment, in order to prepare years of bad returns.

NOT FDIC ENSURED (you can lose your money)



 

Finovate 2010 Best in Show winner PayNearMe offers cash based consumers a cool new way to purchase items online.  Consumers can now purchase an item online and print a receipt.  The consumer can bring that receipt to a 7 Eleven, present the receipt and pay in cash.  Once the payment is made the online retailer is alerted immediately and the purchase is finalized.

PayNearMe currently has partnerships with Amazon, Facebook, and multiple companies that focuses on the Hispanic consumer market, among others.

Check it out at: http://www.paynearme.com/