Pick a Pay - Understanding the Recast

Over the weekend my friend in Florida, Bryant Tutas posed a question about a particular loan product offered by his Wachovia Rep.  It was called the "Pick - a- Pay".

Out here on the west coast we know the P-A-P well.  It's nothing new.  It has been a staple of World Savings for the longest time.  What Bryant was asking about was just one version of the Pick-A-Pay, the "30 year fixed" variety.  It's now being offered by Wachovia as they bought World Savings a couple of months ago. 

What's a Pick a Pay?

Pick a Pay is the name brand that World Savings branded their Payment Option Arms with.  All their Payment Option Loans are called titled with PAP.  Pick a Pay is just the brand name.  many of the lenders have fancy sounding names for their Option Loans.  Quicken calls theirs the "Smart Choice", Countrywide has the "Payment Advantage", Bank of America calls theirs "ManyOptions".  They are all just brand names. 

In the broad sense all of these loans are Payment Option Loans.  They all have a Negative Amortization feature.  Is this good or bad you ask?  They say the Devil is in the details.  Let's look at what makes a Neg Am loan tick - shall we?

Ingredients

To properly understand any Neg Am Loan you must know what goes into it.  Here's the minimum you'll need to know:

• Note Rate - this is the actual interest rate you are paying on the loan.  It might be adjustable, it might be fixed, it might be fixed for a portion of the time.
• Teaser Rate - This is what determines the minimum payment. 
• Term is the life of the loan (30 yrs, 40 yrs, and so on)
• Recast Period - This is the predetermining point in time that your loan will "re-balance" in order to payoff by the set term.
• Recast Percentage - this is the line in the sand at which your loan cannot exceed.  A typical recast percentage might be 110% to 125%.
• Index - The Index comes into play with Adjustable rates.  The Index is the adjustable portion of the ARM. 
• Margin - This is added to the Index to compute the interest rate.  Index + Margin = Rate.  Unlike the Index - your margin will never change.  It is set out in the Note you signed.

Plugging in the Numbers

To illustrate how these all come together let's look at a hypothetical loan.  

Please note:  All rates are inaccurate and are used here just for illustration purposes.   The rates are actually ones that a potential client came to me some time ago.  When they last refinanced, an out of state loan officer sold them on this "bad loan".  Unfortunately I couldn't help them and they eventually lost the house.

• Loan Amount: $400,000
• Note Rate: 8.33%
• Teaser Rate:  1%
• Term: 30 Years
• Recast Period: 5 years
• Recast Percentage - 115%
• Index - 4%. 
• Margin - 4.33%

Given the above figures the borrower would have a monthly statement that has 4 options:

1. Minimum Payment:  $1,287 (loan amount, using the teaser rate and amortized over the term)
2. Interest Only: $2,777 ( loan amount, using the note rate)
3. 30 Yr Payoff: $3,028 (loan amount, note rate, amortized over term)
4. 15 Yr payoff $3,899 (same as #3  but with a 15 year term)

Deferred Interest

If the borrower pays the minimum payment each month the difference between the Minimum Payment and the Interest Only are added to the loan balance.  This is called Negative Amortization but since the lenders don't like words that sound bad, they'll call it Deferred Interest.  In our illustration above, the borrower will add $1,490 this month to his loan balance in "Deferred Interest".

Bring on the Recast

Each month, if the borrower pays only the minimum due, the Deferred Interest will cause the balance of the loan to go up.  If the loan balance goes above the line in the sand called the recast percentage the payment options start disappearing.  (see the red line in the above chart)  That's what happened to this Client.  The loan was scheduled to Recast in 5 years or 115%, whichever comes first.  It's the Recast Percentage that got them. It didn't get them in 5 years, it got them in month 39!   

Here's an actual online calculator from a Lender showing what happened.

In Month 39 the lender took away the Minimum Payment, they took away the Interest Only payment and the borrow was forced to pay $4,096 a month.  The month before they paid only $1,487 - this payment was almost triple.  They couldn't pay and the home went into foreclosure. 

Bad, Bad, Bad...

Looking at this scenario it's easy to how unethical loan officers could sell this loan product and send people down the road to financial ruin.  The media has branded these loans as Evil.   I've seen some honest loan officers who have tried to distance themselves from the negativity of this loan.  "This loan is a bad loan.  I would never allow any of my clients to use this loan".  This is just wrong thinking.

The loan I illustrated above was definitely  a "Bad Loan".  It had a bad margin, a bad recast, bad caps, bad points and fees, and a bad prepayment penalty.    It was sold by a bad loan officer who misrepresented the loan.  It was a bad solution that did not fit the needs of the borrowers.  It was bad from the start.

I'll make the point, and I'll stand up on my soapbox to do it.  It isn't the loan product that is bad.  This loan is (and was) sold to all the wrong people for all the wrong reasons by the wrong people.  Given the right circumstances, with the right people, with the right terms, this loan is a wonderful loan!  Any loan officer that flat out refuses to use this loan is working short sided. 

A true Mortgage Planner knows what I am talking about.  Learn the loan, know the loan.  Apply the best product for the proper situation.

 

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