The Los Angeles Times ran an interesting article today on pay option loans. Essentially, these home loans work just like credit cards in that each month the lender only requires a minimum amount due. This minimum amount though does not even cover the interest due, leading to negative amortization. In other words, by just paying the minimum amount due, the borrower owes more and more each month.
One conclusion you can reach is that negative amortization loans are bad. However, the real lesson I see is the danger of throwing good money after bad. Let’s take a look at the article. The homeowner bought a house in Corona 11 years ago. In that time, his house appreciated in value, growing from $129,995 to over $400,000. The lesson could have been about a savvy real estate investor. Instead, the borrower proceeded to strip out the equity from his house to pay off credit card debts, purchase a car, travel internationally, and invest in stocks and commodities.
Let me restate this. The homeowner pulled money out of an asset that had tripled in value for him over 11 years, and poured it into discretionary spending and investments that ended up losing money for him. Therein lies the big lesson here. You don’t have to read Rich Dad, Poor Dad to figure what went wrong here.
Taking cash out when refinancing isn’t like withdrawing money from your bank account. You take $40 out of your checking account at the ATM and the money is yours. You take $40,000 out when refinancing and you have to pay the money back. That’s the difference.
Los Angeles Times:
A Loan That’ll Get Ugly Fast