Mortgage Products - Negative Amortization & Home Equity Line of Credit

In the previous two articles, we have studied the different types of mortgages from the borrowers as well as from the lenders point of view. In this article we will look at some products which were called the byproduct of financial innovation. At first these products were applauded as being solutions to many problems. However, later when the financial markets went bust, these products ended up aggravating the crisis. There are many such products. However, most of the products are complicated and would be difficult to explain here. In this article, we will have a look at the two most commonly used out of these products i.e. negative amortization and home equity line of credit.

Negative Amortization Loans

Perhaps the most dangerous financial innovation of the subprime lending was a mortgage product known as negative amortization. Colloquially it was also referred to as “step up” loan. This loan was designed keeping in mind the needs of “wannabe” borrowers. This means this loan was designed to lure people to bet on the rise of their future income and take out loans which they will not be able to manage in the future. Banks have denied these charges and state that the risks of the negative amortization loans were well stated. However, borrowers and critics feel otherwise. Let’s have a closer look at this financial innovation.

  • Step up Loans: From the consumer point of view, negative amortization loans were really simple. Instead of having to pay $100 over the entire 30 year lifetime of the loan, borrowers were willing to pay $70 in the first 5 years, and then step it up to $85 in the next 5 years and then $100 for the next 5 and finally $125 for the last 5 years.

    To many borrowers, it made intuitive sense to do so. They figured that their incomes are low at this point of time. However, as and when they spend more times in their jobs, their incomes will always rise and then they will be able to afford the monthly payments. This is how these loans were marketed to entice the borrowers to take mortgages which were beyond their means by conventional lending standards.

  • Payment Less than Interest: The math behind these loans was far more complicated than was being marketed. As we learned earlier that in the amortization process almost 80% of the payments made during the first 5 years go towards paying interest costs. Hence the bank was only charging $70 when in fact the more interest due was $80. This created a dangerous situation in the first five years of these loans.

  • Increasing Principal: Now, the balance $10 i.e. ($80 interest vs. $70 payment) was added back to the principal! This happened month on month and the borrowers without being aware of it were paying compound interest on top of compound interest. The principal would spiral out of control within the first few years. Hence, it was possible that you took a $1000 to begin with and after 5 years of making payments, the balance outstanding was $1300! This could qualify as predatory lending. However, the banks had made the terms clear. It is the borrowers who believed the flashy commercials rather than read the fine print on the mortgage papers.

  • Dangers of Negative Amortization: As we can see from the above case, the negative amortization loan is an extremely dangerous working arrangement. A naive person may not realize that they are actually under water even after making regular monthly payments for 5 years. Also, if the income does not move up as expected, the borrower experiences financial duress. Most of these loans end up in duress or being foreclosed by the banks.

Home Equity Line Of Credit

Another dangerous type of financial innovation propagated by the banks during the subprime mortgage crisis is called Home Equity Line of Credit or HELOC for short. This arrangement allows for an abundance of credit and encourages the unsuspecting borrower to resort to unsustainable financial behavior.

  • Revolving Line of Credit: The home equity line of credit is a revolving line of credit against the amount of equity that you have in your home. Consider the case of a person who has a $100 home and a $60 mortgage on that home. They therefore have $40 equity in the house. The mortgage company would offer them a revolving line of credit which they could use in their day to day lives. Since this credit was backed by a security, the rates of interest were very low.

  • Home Used as a Credit Card: The HELOC allowed people to use their homes as a credit card. They could borrow the money from a mortgage company and spend on non mortgage related stuff. Many borrowers used this line of credit to pay off their credit cards. They also used this line of credit to remodel the house, buy a vacation and a lot of other goods and services that did not need to be purchased. As a result a lot of these households found themselves going back into debt!

  • Dangers of HELOC: HELOC may sound like a good financial advice for a person suffering from debt issues. It sure makes sense to pay 4% interest instead of 36% on the balance on your credit cards. However, a lot of people started misusing the HELOC and went further into debt. They paid down their credit cards using HELOC and then charged more on their credit cards anyways! Of course this is not the banks problem. However, it is a dangerous product and must be sparingly used if it all and that too with extreme caution.

Both Negative Amortization and HELOC were applauded as being cutting edge financial innovations. However, they have done more harm than good. When the subprime mortgage market went down, a lot of people lost their homes and their lives savings thanks to these products.

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