You must understand the pitfalls of ARMs and be prepared to face the worst-case scenario. An adjustable-rate mortgage can offer lower payments in the beginning, enabling you to afford a larger home with a smaller payment, but it is not without risks. These are what make a fixed-rate mortgage a more attractive option for most home buyers.
The interest rate on an ARM varies and may go up or down in accordance with a rate index, such as LIBOR or CMT. The start rate may be lower than the fully indexed rate and your loan may have a floor as well that doesn’t allow the rate to go down below a minimum level. In most cases, the rate is likely to go up at the first adjustment and it may rise even more at subsequent adjustments.
A rise in interest rate will obviously cause your payments to go up, sometimes by a lot. If you have not forethought, you might get surprised, or even shocked, with a large, sudden increase in your monthly payment.
A cap on interest rate or payment increase works just fine to keep in check a sudden rise in payment. However, this may cause you to face another problem. Your monthly mortgage payment may not become large enough, due to a cap, to pay all of the interest due on your mortgage.
This implies that the unpaid interest (also known as deferred interest or accrued interest) will be added to the principal, causing your loan balance to rise and become more than the amount you originally borrowed. This situation is termed as negative amortization, which is typical with a payment-option ARM.
Negative Amortization Cap
To avoid payment shocks or the need of an extra large balloon payment at the end of the mortgage term, you may have a negative amortization cap as well on your ARM. The cap limits the maximum amount of negative amortization (or the total amount you can owe) to a certain percentage (typically 110% or 125%) of the original loan amount. When the amount you owe rises beyond the limit set by the cap, you have your payment increased by the lender to the fully amortizing payment level, overriding any payment increase cap.
Adjustable-rate mortgages, including interest-only and payment-option ARMs, usually come with prepayment penalties. You must confirm with your lender if you need to pay a special fee when you refinance or pay off the ARM early. Some mortgages may allow you to pay no extra fee or penalty for selling your home. Others may charge you to make partial payments as well. It is also important to ask your lender whether you may be able to convert the ARM to a fixed-rate mortgage in future without a conversion fee.