By David Reed | June 4th 2021
Mortgage loans come in most shapes and sizes such as different interest rates, loan terms and others. One term you may have heard of is ‘fully amortized.’ It’s sort of a mouthful but it’s an important feature of most loans today. A fully amortized loan is one where the loan is eventually paid off at a predetermined period of time while making regular monthly payments. This is in contrast to so-called ‘interest only’ loans or ‘negative amortization’ loans. Neither of which is hard to find in today’s lending environment.
That used to not be the case. In fact, there was a period not too long ago where interest only loans were all the rage. Negative amortization, or neg-am was also a financing option. How do those loans work? An interest only loan is fairly easy to figure out. An interest only loan is one where only the interest on the loan is paid each month. This of course results in the loan balance never being paid down unless the borrower makes an extra payment each month towards the loan balance.
Because in the monthly payment where both principal and interest are paid, an interest only loan will logically have a lower monthly payment. The downside? Unless the borrower actively pays down the loan balance, not only will the original loan be untouched but when it comes time to sell the home, it’s possible the selling costs associated with the transaction mean the borrower has to come to the closing table with money instead of receiving proceeds from the sale.
A neg-am loan is a bit more complicated. A neg-am is opposite a fully amortized loan. Instead of the loan balance being paid down each month, it could actually grow. It amortizes in the opposite direction. If the borrower fails to make a ‘fully indexed’ payment which includes both principal and interest, the unpaid portion gets added back to the loan amount. This means the loan balance would be higher than when originally issued. This takes an interest only loan to an entirely new level.
Both of these two loan types contributed to the mortgage and housing collapse in the late 2000s. Loan balances grew instead of getting smaller. Borrowers who tried to ‘flip’ a property using these loans soon discovered some programs were no longer available. Programs such as not having to provide verification of employment or so-called ‘sub-prime’ loans designed for people with damaged credit. This contribution to the financial collapse caused the federal government to issue new guidelines. These guidelines required loans to be fully amortized. No more interest only or neg-am. There were and still are a few loan programs that offer interest only, but neg-am loans are no longer around. The introduction of the fully amortized feature provided a safer lending environment and contributed to the financial recovery in June of 2009.
When you first speak to your loan officer about a new mortgage, all the features of the available loan programs will be provided. But a stated or neg-am loans won’t be one of them.