Two negatives needn’t a positive make
“Shut up. I was reading something last night and came across negative amortisation home loans. Experts have been saying that these loans will cause more trouble in the US in the days to come. I have been up for two hours trying to figure out how these loans work, but have been unable to.”
“So that’s the problem. Let me explain this to you. Say someone has taken a negative amortisation home loan of $190,000 with a tenure of 30 years or 360 months. This is a 5/1 home loan where the interest rate resets after the first five years and then every year after that. The house he plans to buy is priced at $200,000, which means he has to put in $10,000 of his own money. In other words, the bank or the financial institution that gives him the loan has financed 95% ($190,000/$200,000) of the value of the house.”
“But what is different about this loan? From what you have described till now, it sounds just like any other floating rate home loan,” she interrupted.
“Have some patience, my dear. A negative amortisation loan comes with a teaser rate for the first three to four months. Let us say the teaser rate is 2.5% for the first three months of the loan. The equated monthly instalment (EMI) for the first three months thus works out to $750.7. But after three months, the interest rate changes to 6.5% for the remaining 57 months of the initial five year period. Does that mean the EMI should go up?”
“Of course, if the interest rate goes up, the EMI should also go up. That’s no rocket science,” she said.
“That’s where things get a little different in this case — the EMI does not go up. The EMI stays at $750.7 for the next 57 months of the five-year period. And all the extra interest keeps getting added to the loan outstanding. Let me explain in a little more detail. At the end of three months, or the beginning of the fourth month, the loan outstanding is $188,933.1. The interest on this, at 6.5% per year, works out to $1023.4. But the EMI being paid is only $750.7. What this means is that $272.7 ($1023.4-$750.7) of interest is not being repaid. This gets added to the loan outstanding. So the loan outstanding at the end of the fourth month or beginning of the fifth month stands at around $189,205.8 ($188,933.1 + $272.7). On this, the interest to be paid is $1024.9. The EMI being paid is $750.7 and so interest not paid works out to $274.2 ($1024.9 - $750.7). This is added to the loan outstanding, which at the end of the fifth month or the beginning of the sixth month works out around $189,480 ($189,205.8 + $274.2). And this continues. At the end of the 60th month, or five years, the loan outstanding stands at $206,715. This is much more than the $190,000 of the loan that was initially taken. As is obvious, since the interest to be paid is greater than the EMI, no principal is repaid and hence the loan outstanding just keeps growing,” I said.
“That’s interesting. I had never heard of a loan in which the loan outstanding keeps growing in spite of the EMI being paid on time. So what happens after five years?”
“After five years, the rate of interest can go up. Assuming that the rate of interest goes up to 8%, the EMI needed to pay off the loan outstanding of $206,715 over the remaining period of 300 months or 25 years works out to $1595.5. But at this point, there is another clause built into most negative amortisation loans, which gives the lender the option to limit the EMI at 107.5% of the last EMI. This, despite the fact that the actual EMI required to pay off the loan in the remaining period is much higher. So, in the example we have taken, the new EMI will work out to around $807 (107.5% of $750.7). And I need not tell you that this EMI cannot repay even the interest portion of the loan outstanding. All the extra interest that needs to be paid keeps getting added to the loan outstanding and thus the borrower ends up paying interest on interest,” I explained.
“Reminds me of usury. But how does the bank protect itself? They cannot keep the loan outstanding growing beyond a point,” she asked.
“You know, the bank keeps track of the ratio between loan outstanding and the loan that they gave originally. When this ratio hits 1.1, the process of negative amortisation stops and the borrower has to go back to normal amortisation. At the end of five years, this ratio stands at 1.09, in our example. So the negative amortisation is all set to go and normal EMI is about to kick in. As and when this happens, the EMI is likely to go up from around the current $800 level to around $1,600 level. In other words, the EMI is likely to double. And when this happens, the chances of the borrowers continuing to pay are highly unlikely. It needs to be kept in mind that these loans were largely made to borrowers at the lowest end of the market, whose ability to repay was anyway questionable.”
“Interesting. But wouldn’t falling house prices have an impact on this as well?” she asked.
“Yes. A lot of houses right now are now in a negative equity situation wherein the market value of the house is much lesser than the loan to be repaid. So, in our example, if the market value has fallen by 20% to $160,000 from the initial price of $200,000, the borrower has even lesser incentive to keep repaying. This is primarily because he is repaying more than what the actual worth of the house is. Also, as I have explained before, a lot of individuals borrowed money to speculate since the real estate prices were going up. The entire idea was to sell the house as and when the price goes up, repay the loan outstanding and cash in a neat profit. Now, with home prices falling, that logic clearly does not work. More than this, in the US, home loans are non-recourse loans, i.e. the lender can seize only the collateral; the lender cannot go beyond the collateral and seize other assets or money in the bank account. The borrower is not personally liable for it. Hence, there is all the more incentive to default, since the borrower can only seize the house. Also, every time a borrower defaults, the bank seizes the house and puts it up for sale. This adds to the housing prices going down even further.”
“I get it now,” she said. And since banks had securitised away most of their home loans, investors who bought that securitised paper will be in trouble as the defaults increase.”
(The example is hypothetical)
Reference: Tanta: Negative Amortization for UberNerds, www.caculatedrisk.blogspot.com
k_vivek@dnaindia.net
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