Tag Archive: Business



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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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)



 

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