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This mortgage offer definitely has a catch

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Dear Mr. Berko:

I need to buy a home, but I can barely afford mortgage payments of $1,000 a month. I found a condominium for $300,000, and the mortgage broker says he can get me a 1 percent loan over 40 years. My monthly principal and interest payments are guaranteed to be just $1,000 a month for the next five years. At the end of five years, I would have to renegotiate the mortgage rate and probably have slightly higher payments. Five mortgage brokers advertise this 1 percent rate in the local newspaper. I’ve sent the advertisements to you, because I don’t know which one to use. Is one of them better or cheaper than the other?

F.G., Fort Lauderdale, Fla.

Dear F.G.:

First of all, there are no 40-year, 1 percent home mortgages. Those 1 percent advertisements may be criminally misleading and could be injurious to your wealth. Frankly, newspapers ought to be more careful and discriminating about the advertisements they accept.

F.G., 1 percent of $300,000 is $3,000 a year, or $250 per month. Yes, I know the advertisements in your newspaper indicate a 1 percent interest rate and fixed monthly payments of $1,000 over 40 years. Confusing, isn’t it? But it’s supposed to be confusing! If it weren’t, it couldn’t be sold. That 1 percent rate may be the biggest swindle since the Teapot Dome scandal during the Harding Administration some 85 years ago.

Yes, your mortgage interest rate is 1 percent, but just for the first month. Your first month’s payment is $1,000, and at a 1 percent rate the interest cost for the first month is only $250. So the $750 excess is subtracted from your $300,000 mortgage, and the new balance is now $299,250. During the second month, you’re still making mortgage payments of $1,000, but at a 4 percent rate. The interest cost (4 percent times $299,250, divided by 12) is $997.50, so you have a reduction in principal ($1,000 minus $997.50) of a mere $2.50, and the new mortgage balance is reduced to $299,247.50.

However (and here’s the gut punch): that 4 percent is a floating rate, which is tied to a benchmark index such as the 10-year Treasury, the prime rate, the Bond Buyers 20 Index, the London Interbank Offered Rate, etc., and can change every month. Only your $1,000 monthly payment remains the same. When those rates go down, so does the interest rate on your mortgage. But if those rates move up, so will the interest rate on your 40-year mortgage. And here’s where you are gonna get buried — and you may get buried so deep that it will take a steam shovel to dig you out of a huge hole in five years.

Assume interest rates move up to 6 percent on the third month of your $299,247.50 mortgage. At 6 percent, the interest costs for the third month will be $1,496 — but you’re making fixed payments of $1,000 a month. Well, the difference between the new payment and your $1,000 payment is $496, which must be added to the principal on your mortgage. So the amount you owe the bank increases to $299,743.50. If the rate remains at 6 percent, you will pay 6 percent on $299,743.50 for the fourth month, which is $1,498.71. But your payments are fixed at $1,000, so the difference between the two payments ($498.71) is added to your mortgage again, which now has increased to $300,241.21.

After five years of this kind of negative amortization, you easily could owe the bank $350,000 to $375,000 or more, which is a lot higher than your original $300,000 mortgage.

I doubt your mortgage broker will let you in on that little secret. He has probably asked you to sign myriad documents of acknowledgement, and no doubt you blithely initialed every piece of paper put in front of you. Frankly, most of the new genre of mortgage brokers don’t give a hoot that your mortgage amount may be 15 percent or 25 percent higher in five years. This new breed of broker is only interested in collecting his $3,000 to $6,000 fee for brokering a mortgage and getting you out of his office so he can gleefully con new suckers.

If you can “barely afford” to make monthly principal and interest payments of $1,000 a month, you should not be buying a condo for $300,000 — even with a 40-year amortization. At a 6 percent interest rate, your true monthly principal and interest payments will be about $1,500. And when you add taxes and monthly maintenance, your monthly obligation could be as much as $2,100.

Don’t use any of those thimbleriggers who advertise mortgages for 1 percent.

Please address your financial questions to Malcolm Berko, P.O. Box 1416, Boca Raton, Fla. 33429 or e-mail him at malber@adelphia.net.

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