Negative Amortization Involved in Adjustable Rate Mortgage (ARM)

Indeed, compared to fixed-rate mortgage, an ARM is remarkably flexible to homebuyers. Generally, with an ARM, you can purchase larger house than you could otherwise. Also, it is a cheap way to get a house if you don’t expect to stay in for long. Based on the type of ARM, you can benefit from the lower interest rate for the first few years.

However, ARMs have clearly spelled disadvantages such as a negative amortization option that leaves borrowers owing more than they were initially borrowed.

But, what does “negative amortization” mean?

Negative amortization, also known as NegAm or deferred interest, occurs whenever the payment made by the borrower is less than the interest due and the difference will be added to the loan balance. That is to say, even if you are making regular payments, the outstanding balance of your loan would increase during the period of negative amortization, since the accumulated but unpaid interest is added to the outstanding balance.

How does negative amortization on an ARM work?

You know negative amortization can easily happen with pay-option ARMs that allow you to make only minimum payments. In fact, pay-option ARMs are just a type of negative amortization loan.

A pay-option ARM is typically a 30-year ARM that initially provides you with 4 monthly payment options. These options usually include:

• a specified minimum payment

• an interest-only payment

• a 15-year fully amortizing payment

• a 30-year amortizing payment

When you choose a specified minimum payment or an interest-only payment that is less than the accruing interest, negative amortization would occur. For example, if you make a minimum payment of $500 and the ARM has accrued monthly interest in arrears of $800, $300 will be added to your loan balance. Furthermore, your interest-only payment in the next month will be calculated depending on the new, higher principal balance.

Let’s look at a specific example of negative amortization quoted from the Federal Reserve Board.

• Loan type: 30-year pay-option ARM

• A minimum interest rate of 2% for the first 3 months (your minimum payment for the year would be about $739)

• An interest rate of 6% for the remaining 9 months of the year

In the example above, once the interest rate of 6% is applied to your loan balance, your minimum monthly payments are no longer covering the interest costs. If you go on with minimum payments on the loan, your loan balance would be $1,118 more than you originally borrowed at the end of the first year.

What about traditional ARMs? Actually, an adjustable-rate mortgage is not designed as negative amortization loan, but can become negative amortization if its maximum rate increases or it has a payment cap.

As we know, with an ARM, your interest rate can change periodically (e.g. monthly or annually). Some of ARMs include a payment cap which is known as a limit on how much your monthly payment could increase at the time of each adjustment. The cap is usually expressed as a percentage of the previous payment – usually 7.5% annually on pay-option / negative amortization loans.

This helps prevent your monthly payments from increasing greatly when your interest rate rises. For instance, with a 7.5% payment cap, a payment of $1000 could increase to no more than $1007.5 in the first adjustment period.

Let’s suppose that you have an ARM loan with an initial interest rate of 4%. In the first year, your rate increases by 2%, but your payments can increase by less than 7.5% in any one year. Here is what your payments would look like:

• 1st year with interest rate of 4%: Your monthly payment would be about $477

• 2nd year with interest rate of 6% (without payment cap): Your monthly payment would be about $572

• 2nd year with interest rate of 6% (with payment cap): Your monthly payment would be about $520

• Difference in monthly payment would be $52

You should know that as payment caps only limit how much your payment could increase (not interest-rate increases), payments in some cases don’t cover all the interest due on your loan. If this happens, it means negative amortization occurs. The unpaid interest in your payment is automatically added to your loan balance and your interest may be charged on that amount. Thus you may owe the lender more than you did at the beginning.

Now, some of you may be wondering: why are there people using a negative amortization option? You know negative amortization option is intended to lower your monthly payments. Some people use home loans with this option to get into a house they otherwise cannot afford. However, they usually believe that they will have more income in the future.

There are also some consumers who use mortgage with negative amortization when they believe home prices will increase in the near future. Anyway, be noted that it is just a way to lower monthly payments. While it can make sense in some cases, you should know that using this method really adds risk and leverage.

However, be aware that some mortgages also come with a cap on negative amortization (also known as the neg am limit). The cap usually limits how much you can owe in total – usually from 110% to 125% of the original loan amount.

Once you get to that point, your lender will fully amortize your outstanding balance of your loan over the remaining term. At that time, your payment cap will not apply and your payments could increase significantly.

For example, a $150,000 ARM with a 110% NegAm cap will typically adjust to a fully amortizing payment, based on the current fully indexed interest rate and the remaining term of the loan, if negative amortization causes the loan balance to exceed $165,000. With a NegAm cap of 125%, this will happen if the loan balances reach $187,500.

Also, bear in mind that negative amortization also has a recast period usually of 60 months (5 years). This means most mortgage loans only allow negative amortization to happen for less than 5 years.