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November 19, 2001
"I am a
recently-widowed 54-yar old with a house worth $1.1 million, a high-rate
mortgage of $450,000, but not much income. I can only afford to pay $2,000 a
month on principal and interest, plus taxes and insurance.
I am prepared to use up my equity of $650,000 to stay in the house, but
don�t know how to do it. A
mortgage broker suggested two options. One
is to refinance into a monthly negative amortization ARM that has a payment I
can afford. The other is to borrow more than $450,000 on a fixed-rate mortgage
and invest the difference to supplement my income. The broker didn�t know
which was better and suggested I ask you."
Based on information provided
by your broker, the payment on this adjustable rate mortgage (ARM) is $1885 for
the first year, which is why she thought it might be suitable for you.
This payment, however, doesn�t cover the interest in the first year,
which results in negative amortization; the balance grows over time before it
begins to decline. As a result the
payment must also rise.
If market interest rates are
stable, the payment on this ARM will rise by 7.5% in month 13 to $2026, in month
25 to $2178, in month 37 to $2342, and in month 49 to $2517.
In month 61, it will jump to $3295 because of a recast provision that
requires that the payment at that point be �fully amortizing� -- meaning
that it will pay off the loan over the remaining term.
If interest rates rise in future years, the payment increases beginning
in year 4 could be even larger.
This ARM is for people who
can expect rising incomes in future years.
In your case, the payment will become unaffordable within a few years.
Even if you can meet the 7.5% payment increases, larger increases will
kick in somewhere between the 4th and 6th year, depending on what happens to
market interest rates. At that
point, you will be forced to refinance and start the process again.
An alternative is to borrow
$800,000 on a 30-year fixed-rate mortgage, investing the $350,000 cash taken out
to supplement your income. Assuming
a rate of 6.625%, your mortgage payment would be $5122, or $3122 more than you
can afford. This is the amount you
would have to withdraw each month from your investment fund.
If you earn 3% on the investment, your fund would last for about 11
years.
At that point, the balance on
your mortgage will be paid down to $665,000, so you will still have substantial
equity. And since you will be 65
years old, you can take out a reverse mortgage, which is a much more efficient
way of living off the equity in your home.
The fact is that we don�t
really have a good instrument for house-rich but income-poor people under 65.
Increasing the balance on your mortgage to create an investment fund is
inefficient because the mortgage rate you must pay on this money is much higher
than the investment rate you will receive. There should be better ways to do it.
As one possibility, the
lender making a 30-year loan at 6.625% could accept a payment of $2,000 a month
for the life of the mortgage. Over
the 30-years, the balance would grow at an annual rate of 2.67%, reaching
$999,000 at term. This loan would
have minimal default risk to the lender, since the balance at term would be
below current property value, never mind the appreciation that is bound to occur
over 30 years.
Lenders wouldn�t make this
loan, however, because of the high interest rate risk.
If market rates rise, the lender doesn�t get back any money at all to
reinvest at the higher rate. On the
contrary, in effect the lender must keep advancing new money to cover the
difference between the payment and the interest.
This risk to the lender could
be sharply reduced by converting the instrument into a 7-year balloon. Since the balance would be due after 7 years, the rate would
be reset at the market at that point. While
7-year balloons exist now, they all calculate payments that would fully amortize
over 30 years. A negative
amortization balloon loan would be a new instrument, available only to borrowers
who have very substantial equity. This
would be a nice niche product for an enterprising niche lender.
Copyright
Jack Guttentag 2002
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