Your second and third payment options are based on the fully indexed rate, the true rate of interest you are paying.  This is typically tied to an index, for example the MTA index, and includes a margin.  If your margin is 3%, and the MTA is 4.5%, your fully indexed rate is 7.5%.  So your second payment option on our $300,000 example would be interest only at 7.5%, or $1875.  Your third option would be the fully amortized payment, or $2098. 

So in this example, you only have to pay $965 each month, but you owe $1875 (the interest only payment).  If you make that minimum payment each month, the difference gets added on to the principal balance of your loan.  In this example, you are adding $910 to the balance of your loan each month that you make the minimum payment.  Your minimum payment in these loans will typically increase each year by 7.5% of this minimum payment, so year two of this example your minimum payment would increase to $1037.  Each year this increases a little bit until you reach the interest only payment or you reach the end of the minimum payment option term, usually 3-5 years.

These loans also have a feature that will cap the amount of principal that can be added to your loan amount.  These caps can range from 110%-125%.  So on this loan, with a 110% cap, your loan would cap out when your principal balance reaches $330,000.  When this happens, your minimum payment goes away, and you only have the option to pay the fully indexed rate.  Additionally, these loans have a recast feature.  If you are paying interest only, or the minimum payment each month, you will never pay the loan off.  After year 5, sometimes year 10, the loan is recast and put on a shorter amortization. 

Amortization is a calculation of what you need to pay each month to pay your loan off in x amount of years.  So a 30 year amortization is a payment that you will make that will pay your loan in full after 30 years.  When your loan is recast, say after year 5, you have used up 5 years of your 30 year loan term.  Now your loan term is 25 years, and your recast puts you on an amortization schedule of 25 years.  The payment on a 25 year amortization of the same $300,000 at 7.5% is $2217, as opposed to the $2098 on a 30 year amortization.

These loans have great features for some borrowers.  If you are self employed, or work in a commission based job where your income can fluctuate from month to month, it gives you the freedom to make that minimum payment during your slow months.  During the months you are making good money, you should be making the higher payments.  If you plan on staying in your property only short term, a neg-am loan may be a good decision as well.  You can free up cash flow monthly, and when you sell, pay the additional principal at that time.  Also, if you expect your income to increase significantly in the near future, a neg-am loan could be a good tool to use as a bridge loan.  Where people get into trouble is when they use these loans and the minimum payments as long term solutions.  Your principal balance is increasing every month you make that minimum payment, and at some point you will be forced to make the higher payments or refinance into a new loan.

When the market was hot and real estate was appreciating every month, this was not a problem.  You could make that minimum payment, refinance into another neg-am loan, and continue to make minimum payments.  In today’s market, with real estate prices declining, this option is off the table for many people.  If you took out a loan for $300,000 two years ago and made those minimum payments, your principal balance may be around $320,000 now.  If your home has declined in value, you may not have the equity left to facilitate a refinance.  You can see where this could lead to trouble. 

So if you currently have a neg-am loan, what options do you have now?  Rates are falling as we speak, and it is a great time to look at a refinancing to a fixed rate loan.  Another option is to look into an interest only loan, or a hybrid neg-am loan with fixed rate features.  Your payments would not increase as much as a fully amortized loan, and you have the option every month to make higher payments if you want to pay down the principal.  Either way, unless you have a specific reason for your neg-am loan, now is a good time to explore other options.