Most adjustable-rate mortgages aren't as complex as they may seem. But add a “minimum-payment” option, and a lot more complexity sets in to the basic ARM.
Typically, adjustable rate mortgages, or "ARMs" for short, start out with an introductory interest rate, after which the rate periodically adjusts to an index rate plus a margin, subject to interest rate caps. Once you know what the adjustment period, index, margin and caps are, you can make your payment calculations and that's all there is to it.
Interest rate adjusts despite fixed payment
A payment-option ARM also starts out with an introductory rate that keeps your payments lower at the start of your mortgage. But a payment-option ARM is essentially a one-month adjustable rate mortgage. That means the introductory rate lasts only one month before it's adjusted to the current index plus the margin, again subject to any applicable caps. The new rate then adjusts again every month. If interest rates are rising, a frequent adjustment can push your rate up faster, yet if interest rates are falling, a frequent adjustment can push your rate down faster too.
Even though the interest rate adjusts monthly, the minimum payment is fixed for the first year. That means the minimum payment doesn't reflect the interest rate that's being applied to the loan balance. Your interest rate and loan balance can climb quickly even though your minimum payment doesn't budge.
To lessen the risk of option-ARMs, some lenders offer hybrid option ARMs, which have a fixed rate for the first one, three or five years.
Minimum payments trigger 'negative amortization'
The minimum payment allows you to pay less, but typically doesn't cover all of the interest you owe for the payment period, much less make a dent in the principal.
So what happens to the unpaid interest?
It's added to your loan amount.
This increase in the loan balance is called "negative amortization," which means that even though you made a payment, you still owe more, rather than less, on your loan. Negative amortization results because not one cent of your payment was applied to the principal. Instead, your entire payment was applied to interest, but still wasn't enough to pay all the interest you owed for that period.
Each time you make only the minimum payment, the unpaid interest is added to the amount you owe and your monthly adjusted interest rate is applied to the new total.
For example, say you had a $100,000 mortgage and the interest rate was 6 percent. Your payment options might be:
Minimum payment: $400
Interest-only payment: $500
30-year fully amortized payment: $600
15-year fully amortized payment: $844
Each time you made only the minimum payment, your loan balance would increase $100 to cover the unpaid interest. If you made only the minimum payment for 12 months and your interest rate didn't change, your loan balance would be $101,200, which means your debt would have increased, instead of decreased.
Recast reboots your mortgage
If your loan balance, including the accumulated unpaid interest, added up to more than 110% of the amount you originally borrowed, your loan likely would be recalculated, or in loan-speak "recast," to reflect how much you then needed to pay. A $100,000 loan would be recast when your balance reached $110,000.
This recalculation could occur during the early years of your mortgage, depending on interest rates and how frequently you made only the minimum payment. When your loan is recast, your new payments will be higher because your loan balance is now 10 percent larger. Payment-option ARMs also recast automatically every five years, regardless of the balance.
The initial minimum payment on a hybrid option-ARM loan is set so the loan isn't recast during the initial period. Yet the minimum payment wouldn't necessarily avoid negative amortization. The only ways to avoid negative amortization are to pay at least the interest-only amount every month or make additional payments.
Smart money plays it safe
Payment-option ARMs offer flexibility, but only with great risk. If you want to stay on the safe side:
- Don't use the minimum payment to figure out the maximum amount of money you can borrow.
- Remember, the minimum payment isn't enough to pay off your debt and could result in negative amortization.
- If you don't understand how your loan works, get help before you get socked with payments you might not be able to afford.