Should You Refinance Into a Negative Amortization Mortgage?
Don Taylor, a financial advisor for Bankrate.com, has a straightforward answer to the mortgage refinancing question below. Here’s a summary of the situation:
Q: My friend’s mortgage broker is talking him into refinancing his current 5 percent ARM into a negative amortization mortgage. The sales pitch that if he pays the minimum amount due every month to the bank, and he puts the difference in what he is currently paying into an interest-bearing account (high rate money market, for example), he would have his house paid off in 10 years based on the power of compound interest on his money market accounts.
For example, he currently pays $2,000 a month for his mortgage. The new negative amortization mortgage would call for a $650 payment. He would then take the difference of those two amounts and put it into a money market account. Is this sales pitch legitimate?
A: With negative amortization, the monthly loan payment doesn’t have to be large enough to cover the monthly interest expense. When the loan payment doesn’t cover the interest expense, the outstanding loan balance increases by the shortage.
The home loans are typically structured so that after a while the mortgage payment increases to reflect the higher outstanding loan balance.
For the power of compound interest to allow him to pay off the loan faster, the after-tax interest rate on his investments has to be greater than the after-tax cost of his mortgage.
Money market rates are very attractive right now, and he could earn over 5 percent pretax in a money market account or a money market mutual fund, but it’s likely that the after-tax cost of his mortgage is still greater than the after-tax return on his money market investments.
You can’t ignore the tax deductibility of mortgage interest rate expense and the taxes due on the investment earnings. Including the relevant tax impacts would make an even stronger argument for not going the interest-only route.
Negative amortization on the interest-only home loan wouldn’t help the situation because you are increasing the interest due on the mortgage.