Pick-a-pay mortgages, otherwise known as negative amortization loans, have surged in popularity in the last five years — so much so that they've been highly featured, and in turn scrutinized, from USA Today to the cover of Business Week.
The pick-a-pay mortgage is a complicated loan. Most consumers don't really know what they're getting aside from the super low minimum payment option, mainly because brokers and loan officers tend to push that aspect of the loan above all else.
Pick-a-pay mortgages carry four "flexible" payment options, including:
- Minimum payment (usually as low as 1%)
- Interest-only payment
- 30-year fully amortized payment
- 15-year fully amortized payment
The minimum payment is the focal point of all the scrutiny. If a borrower decides to pay the minimum payment, they essentially pay less than the actual interest rate on the loan. In doing so, they defer the actual interest owed.
The owed interest begins to build up on top of the existing loan balance until a set limit is reached, which ranges between 110-125% of the original loan balance. Once this limit is reached, the borrower loses the ability to use the minimum payment option and the loan recasts with a new minimum payment that will be substantially higher than the 1% start rate.
This is the point where serious problems arise. For example, a $500,000 loan amount with a 7.5% interest rate would carry a 1% minimum payment of $1608.20, while the interest-only payment would be $3,125.00.
If the borrower chooses to pay the 1% minimum payment each month, they would be tacking on nearly $1,600 in owed interest each month. To add insult to injury, the interest rate is adjustable, so that payment will likely keep increasing as the index goes up the life of the loan.
To make matters even worse, once the borrower loses the ability to the pay the minimum payment, they owe anywhere from 110-125% of their original loan balance, so they're faced with a substantially higher monthly payment on a higher overall loan balance.