A payment cap can put a limit on how much your monthly payment on an ARM, even if you have a payment-option ARM, can increase when it is adjusted. Not all mortgages have payment caps, and some may have interest rate caps as well. Expressed in percentage, a cap may refer to the maximum decrease or increase in the payment on an ARM at a payment adjustment date.
It is usually a month after the interest rate adjustment that a change in payment occurs, and the borrower is notified of the payment change date at least a month in advance. Your payment due date doesn’t change, but the amount that you must pay can go up or down depending on the change in interest rate. The period between payment changes is known as payment adjustment interval, which may or may not be the same as the interest rate adjustment period.
Taking an example
Let us assume you have a monthly mortgage payment of $1,000. If you have a 7.5% payment cap on your ARM, then your payment after the first adjustment can’t be more than $1,075. At the second adjustment, the highest a payment can go up is $1155.62, which is $1,075 plus 7.5% of $1,075.
What if the interest grows more than the payment can cover?
There is something known as negative amortization. It happens when your effective payment is less than the amount needed to cover a rise in the interest rate. Suppose your new payment should be $1,150, after an increase in the interest rate at the first adjustment. But a cap on the payment limits it at $1,075. The difference $75 ($1,150 – $1,075) will be added to your loan balance, which may gradually become more than the amount you originally borrowed. This situation is termed as negative amortization.
What may be the possible way out in case of negative amortization?
A borrower must make a balloon payment if the term has ended but the money is still owed. Another option would be recast payment, which refers to a periodic increase in payment irrespective of the cap. A recast payment can also refer to a reduction in payment when borrowers have made extra payments and need to have their fully amortized payment recalculated. Remaining principal balance and remaining mortgage term are used for the calculation of recast payment.