A Closer Look At The ‘Devil Loans’
Posted @ 11:01 am - Filed under Cool Info, Financing
Let’s take a quick look at how sometimes a loan with negative amortization can be a legitimate choice for an investor. The extreme viewpoints on both sides of this type loan are well known. Either folks go for the relatively lower payments, damn the torpedoes, or, citing the increasing loan balance proclaim to one and all it’s the devil’s loan.
Let’s take a quick, down and dirty look.
There are a couple neg-am loans out there today — what I’ll call the traditional, and a recent creation, the hybrid.
Here are the significant differences. Traditional — T Hybrid — H
Here are the numbers. I’ll use purchase price of $120,000 and a loan amount of $100K to make the numbers a little easier to follow. A 30 year term will be applied to both. MTA (moving treasury average) will be used as the index with a margin of 3 for the Traditional neg-am. The hybrid is an unchanging fixed index rate and payment. ‘Spread’ is the difference between the payment rate and the indexed rate. This difference is the unpaid interest which is added to the loan balance.
Excuse the format — I’m having tech problems.
Traditional / Hybrid
Payment Start Rate 2% 3.99%
Payment $370 $477
Indexed Rate 8.32% 7.25%
Spread 6.32% 3.26%
1st YR Neg-Am +/- $6,300 $3,250
Loan Bal EOY 1 $106,300 $103,250
That’s just a snapshot of the first year’s differences of a traditional neg-am and a neg-am hybrid. Now let’s look at this from the investor’s decision making viewpoint.
What does the investor have to believe to choose either one of these loan types? They have to believe the area in which the property is located will rise in value during the holding period. And not just rise, but rise by a minimum annual rate.
But what rate would that be?
There are two factors at work here. First, and most obvious is the property’s appreciation rate. However, the other factor is just as important — tax savings provided by the property’s depreciation. For this example we’ll use an easy figure to account for the combined tax rate of state and federal — 1/3. For some that won’t be enough, and for others it will be a little too much. It works.
If your annual depreciation is $9,000 annually, your tax savings is $3,000/yr. This means the necessary appreciation rate (to account for the added loan balance) in this example will be reduced by that amount each year.
At what rate must the property appreciate in order to at least offset the increased loan balance? Don’t answer yet — it’s a trick question. First, we need to apply the $3,000 tax savings towards offsetting the loan balance increase.
Traditional / Hybrid
1st yr neg-am $6,300 $3,250
- Tax Savings $3,000 $3,000
Net Loss $3,300 $250
The net loss figures for the two loans show the dollar amounts by which the property values need to rise. The traditional neg-am must increase in value at least $3,300, while the hybrid must go up by only $250.
Using the original purchase price of $120,000 — the following is true.
The traditional must appreciate 2.75% the first year to ‘break even’. The hybrid must appreciate .002%. Pretty risky, eh? Yeah, and I’m a Yankees fan. 
Now go back and read all the media hype about those devil neg-am loans. The higher of the two required appreciation rates an investor had to have to stay even was a lousy 2.75% - the hybrid essentially didn’t need any appreciation that first year. The thing is, because the margins on the traditional neg-am loans are so high these days, the required appreciation is way higher than it was even two or three years ago. As a matter of fact, I clearly remember several clients with aged loans sporting indexed interest rates under 5%! And this was lower than owner occupied home loans then. Wow.
The BawldGuy’s Point: Clearly, these loans allow for significantly lower down payments due to their low, low monthly payments. This can, if an investor is so inclined, (smile developing) buy extra properties here and there. If you are skeptical, take this same $100,000 loan - and use the typical 30 year, 7% fixed rate approach. Then figure what your down payment would have to be to ensure you didn’t end up with negative monthly cash flow.
It’s not always the way to go by any stretch of the imagination. Just like low down payments aren’t the way to go every time. Heck, I used to think investing in San Diego would be a forever thing. Now I’m screaming from the mountain tops for investors to grab their equities and get outa Dodge.
If you come away from this post with nothing else, come away with this: Neg-am loans are not inherently good, bad, ugly, or dangerous. They’re a tool in your workshop. A hammer is just a tool — until it’s used for something for which it’s not intended — at which time it can indeed become lethal.
Common sense — go figure.
This entry was posted on Thursday, May 3rd, 2007 at 11:01 am and is filed under Cool Info, Financing. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.
