Flexible Payment ARMs

One common type of adjustable rate mortgage (ARM) is the flexible payment ARM. This mortgage is described in this section, and is important because it is the mortgage type that most commonly features negative amortization. The flexible payment ARM (FPARM) also provides a useful look at how negative amortization works as well as some of its dangers.

FPARMs provide attractively low monthly payments to consumers by providing a combination of payment caps and interest rates that adjust monthly with no limits. Note: The exception to this rule is the legally required limit on the maximum rate that can be charged over the loan’s life.

Low monthly payments like those offered by FPARMs are highly attractive because they allow some buyers to afford more expensive houses than would otherwise be possible, or pay off debts. It is easy to think of things to do with the monthly savings, and even easier to let the low payments lead you to ignore the downsides of FPARMs.

FPARMs feature a very low initial rate, called a “teaser”. After the first month, this rate will almost certainly increase, since it is often lower than even the margin used as the baseline to calculate the rate, along with a changing index. The use of a very low rate to determine your first monthly payments results in negative amortization, meaning your payments will not cover the interest owed, and the difference will be added to your loan’s balance.

However, this process will not go on forever. Though payments can generally only rise seven or seven and a half percent a year, there are two important exceptions. First, payments are usually set to be recast every five years or so. Recasting will make the payments match up with the amount required to pay off the loan fully at the end of term, without regard to how much of an increase this represents.

Payments may also be raised when the negative amortization cap is reached. This cap sets a limit on the total loan balance, and can range anywhere from 110 to 125 percent of the original balance. Once this limit is reached, the payment immediately recasts automatically. This can be even worse than the periodic monthly recasting, since it is harder to plan for such an occurrence.

Overall, FPARMs represent a big gamble because of negative amortization issues. They assure low initial payments but also introduce the possibility of severe payment shock in the future.