Beware of ARMs using negative amortization

STARTING OUT

September 18, 1994|By Dian Hymer

What is negative amortization?

Negative amortization is an increase in the principal balance of a loan when the monthly mortgage payment is insufficient to pay the interest owed.

A conventional fixed-rate mortgage does not work this way because each monthly payment is enough to cover all interest owed for that period.

Negative amortization is most often associated with adjustable-rate mortgages (ARMs) that have a payment cap. A payment cap puts a limit on how much the monthly payment can rise or fall when it adjusts. Typically, a payment cap will be 7.5 percent of the previous payment amount.

For example, let's say that you have a $150,000 adjustable-rate mortgage with a 7.5 percent payment cap and a current interest rate of 6 percent. Your current monthly payment is $900, which pays the entire interest owed.

This payment will be in effect for one year, at which time it will adjust if interest rates have changed. During the year, suppose the interest rate on your loan increases to 7.5 percent. Without a payment cap, your monthly payment would jump to $1048.50. But, since your loan has a payment cap, the maximum monthly payment the lender can require you to pay at the next adjustment will be only $967.50.

Even though your payment is capped, you are not relieved of the responsibility for paying the additional interest due. Your payment is simply deferred. Any interest that's not paid when due is added to the remaining loan balance. When this happens your loan balance increases, when you send your monthly payment.

Negative amortization can be particularly risky when property values are declining. In this case, you could end up with a loan balance that's higher than the market value of your property. You might wonder why anyone would want a loan that has a payment cap.

If interest rates shot up at the same time as you suffered an economic hardship, you might welcome a payment cap, which would keep your expenses down until your financial picture improved. ARMs with payment caps are usually re-amortized every 5 years or so, or when the remaining balance increases to 125 percent of the original loan balance. At this point, your monthly payment is not protected by the 7.5 percent cap and could jump dramatically.

FIRST-TIME TIP: Even though an ARM has the possibility of negative amortization, you don't have to let this occur if you're diligent and disciplined. The lender gives you the option of making the "minimum payment due" based on your payment cap, or you can make a fully amortized payment, which will pay the entire amount of interest due at that time. If you consistently make a fully amortized payment, you won't have negative amortization.

Dian Hymer's column is syndicated through Inman News Features. Send questions and comments care of Inman News Features, 5335 College Ave., No. 25, Oakland, Calif. 94618.

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