Adjustable Rate Mortgages and Negative Amortization

For many borrowers, adjustable-rate mortgages (ARMs) are an attractive means of qualifying for a home. However, fewer borrowers realize the potential negative amortization problems these loans can create.

Adjustable Rate Mortgages

ARMs are popular among home buyers due to their initial interest rates, which are typically much lower than those of fixed-rate loans. This lower rate allows homeowners to afford homes that might otherwise be beyond their financial reach with a fixed-rate mortgage.

However, the potential risk associated with ARMs is well known. Borrowers face the possibility of interest rates increasing over time, which can lead to financial hardship when monthly mortgage payments rise. If rates and payments increase too much, borrowers may struggle to make payments and risk losing their homes.

To mitigate the fear of rising rates, many lenders use caps on rate increases to entice homeowners. These caps limit the amount the monthly payment can increase within a specified time period, often one year, with a typical rate increase limit of one percentage point. While these caps can make borrowers feel more secure, lenders may not fully explain all the details.

Negative Amortization

In many ARMs, the caps apply only to the monthly payments due on the loan, not to the actual interest rate being charged. This can lead to a situation where you make the monthly payments but still see the principal of your loan increase—a situation known as negative amortization.

Negative amortization can be best understood through the example of credit card debt. If you make only the minimum monthly payment on your credit card, it may not cover the interest charged for the month, resulting in an increased total balance on your next bill. Similarly, with an ARM, your monthly payments may not cover the interest accruing on the loan, causing your loan balance to grow.

To avoid this financial pitfall, it is crucial to read the fine print of your ARM agreement and fully understand how any caps apply to your loan. Whenever possible, steer clear of negative amortization.

By carefully reviewing the terms and conditions of your mortgage and seeking professional advice, you can make informed decisions and avoid the potential risks associated with ARMs.