By Dian Hymer
A conventional fixed-rate mortgage has an interest rate that never changes, and the borrower always makes the same monthly payment. Adjustable rate mortgages (ARMs) have interest rates that fluctuate during the term of the loan. The monthly payment can vary.
The "fully indexed" interest rate on an ARM is calculated by adding the index (which is a measure of the cost of money, such as treasury securities) to a margin (the lender's profit, usually 2.4 to 3 percent). ARMs often start at a "teaser" or discounted rate that is lower than the fully indexed rate.
There are lots of different ARMs, but they all can be divided into two basic types. One type has an interest rate cap. The other type has a payment cap.
An interest rate cap sets a limit on how high the ARM interest rate can go at each adjustment, or during a given period of time. This type of cap is called a periodic cap.
A payment cap limits the amount that the monthly payment can increase when the ARM interest rate goes up. Typically, the monthly payment can increase by no more than 7.5 percent. Payment caps are usually in effect for one year.
ARMs that feature periodic interest rate caps don't have payment caps. When the interest rate rises, so does the amount of the monthly payment. The borrower is always required to make a monthly payment that will fully amortize (payoff) the loan (principal and interest) over the loan term. There is only one payment option: a fully amortizing payment.
ARMs with payment caps are "payment option loans". Payment option loans provide the borrower with various payment options to choose from.
Let's say you borrow $300,000 using an ARM with a payment cap feature. The loan starts with a teaser rate of 4.95 percent which is in effect for 3 months. The initial monthly payment is $1,601 which stays in effect for the first year of the loan.
But starting with month 4, the teaser rate expires and the fully indexed interest rate (7.23 percent) goes into effect. At this point, the lender offers you a choice of three payment options.
The first option is to pay the "minimum payment due" which is $1,601. Alternatively, you can make a "fully amortizing payment" of $2,042. Or, you can make an "interest only payment" of $1,807.
When a payment cap goes into effect (or stays in effect as in the above example), the borrower doesn't pay all the interest owed for that period. The interest that isn't paid is added to the principal so that the mortgage balance increases, rather than decreases, with each payment. This is negative amortization.
First Time Tip: Borrowers can avoid negative amortization by ignoring the payment cap and making a payment that covers the interest owed (either the fully amortizing payment or the interest only payment).
Lenders limit the amount of negative amortization they will allow to 110 or 125 percent of the original mortgage balance. At that point, the loan is recast and a new payment schedule is established so that the loan will be paid off in full during the remaining term. Also, if you always selected the interest only payment option, the loan will be re-amortized at some point so that the remaining monthly payments will fully pay back the loan.
The Closing: Payment option loans offer borrowers flexibility on their monthly mortgage payments. This can come in handy during a financial pinch, such as when you're buying a new home before you've sold your old one.
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