ARMs, Artful Deception and Amortization

Adjustable rate mortgages (ARMs) are sometimes difficult to sell. First of all, they are far more complex than fixed rate mortgages, and complexity is sometimes seen as a negative value by borrowers. If borrowers have trouble easily understanding the ARM concept, they are less likely to choose it. A related point is that ARMs involve more risk than fixed rate mortgages, and many people are too risk-averse to seriously consider an ARM.

For these reason, lenders sometimes try to convince people to choose an ARM through statements that aren’t necessarily false, but at the same time are deceptive. The deception comes through what they statements fail to say, or through stating a point in a way that purposefully leads a borrower to draw an erroneous conclusion.

A good example of one of these statements involves negative amortization. In response to a borrower’s concerns about negative amortization, a lender responds that there is a cap on the amount of negative amortization allowed. The first step in analyzing this statement is confirming that is absolutely true. Most loans that allow negative amortization DO have a cap on the amount allowed.

However, this is only a small part of the story. The statement above leads borrowers to draw the conclusion that this negative amortization cap protects them in some way. This, unlike the statement itself, is far from the truth. The cap does keep the loan’s balance from getting too oversized.

However, when the cap is reached, the consequences for the borrower are mostly negative. At this time, the borrower’s monthly payments are recalculated to make the loan fully amortizing in the remainder of its term. This recalculating is done without regard to any payment caps on the loan. This can result in a large increase in monthly payments, which is not the type of protection for which most borrowers are looking.