That is, if the interest rates rise to the point that the monthly mortgage payment does not cover the interest due, any unpaid interest will be added to the loan balance, so the loan balance increases. However, one also has the option to pay the minimum monthly payment, or the fully amortized amount due.
The advantage of negatively amortizing loans is that one can control cash flow with a relatively stable payment, take advantage of low interest rates relative to the market at any given time, and pay back the money borrowed today at a depreciated value years from now because of natural inflation.
With most ARMs, the interest rate can adjust every 6 months, once a year, every 3 years, or every 5 years. The interest rate on negatively amortized loans can adjust monthly. A loan with an adjustment period of 6 months is called a 6-month ARM, with an adjustment period of 1 year is called a 1-year ARM, and so on. Most ARMs offer an initial lower interest rate than the fully indexed rate (index plus margin) during the initial period of the loan, which could range from 1 month or a year or more.
With fixed-period ARMs typically result in 3-10 years of fixed payments before the initial interest rate change. At the end of the fixed period, the interest rate will adjust annually. Several types of fixed-period ARMs exist, including 30/3/1, 30/5/1, 30/7/1 and 30/10/1. These loans are typically linked to the 1-year Treasury securities index. Adjustable rate mortgages with an initial fixed period usually have a first adjustment cap. This cap limits the interest rate one pays the first time the rate is adjusted. However, first adjustment caps vary with type of loan program.
The advantage of these loans is that the interest rate is lower than for a 30-year fixed because the lender is not locked in for as long so their risk is lower and they can charge less. However, one still gets the advantage of a fixed rate for a period of time.
Two-step mortgages have a fixed rate for a certain time, most often 5 or 7 years, and then interest rate changes to a current market rate. After that adjustment the mortgage maintains new fixed rate for the remaining 23 or 25 years.
Some ARMs come with option to convert them to a fixed-rate mortgage at designated times, usually during the first 5 years on the adjustment date. The new rate is established at the current market rate for fixed-rate mortgages. The conversion is typically performed for a nominal fee and requires virtually no paperwork. The disadvantage is that the conversion interest rate is typically a little higher than the market rate at that time.
The other kind of convertible mortgage is a fixed rate loan with rate reduction option. If rates have dropped since the time of closing, it allows one under some prescribed conditions for a small conversion fee to adjust the mortgage to the current market rate. Generally, the interest rate or discount points may be a slightly higher for a convertible loan.
Graduated Payment Mortgages (GPMs)
Graduated payment mortgages have payments that start low and gradually increase at predetermined times. A lower initial payment allow one to qualify for a larger loan amount. The monthly payments will eventually be higher in order to catch up from the lower payments. In fact, the loan will be negatively amortizing during the early years of the loan. Then, the principal will be paid off at an accelerated pace through the later years.
Lenders offer different GPM payment plans, which vary in the rate of payment increases and the number of years over which the payments will increase. The greater the rate of increase or the longer the period of increase, the lower the mortgage payments in the early years.
Buydown Mortgage temporary buydown is the type of loan with an initially discounted interest rate that gradually increases to an agreed-upon fixed rate usually within the first 3 years. An initially discounted rate allows one to qualify for a greater loan amount with the same income and provides the advantage of lower initial monthly payments for the first years of the loan when extra money may be needed for items such as furnishings or home improvements. To reduce monthly payments during the first few years of a mortgage, an initial lump sum payment to the lender is made. If cash is not readily available for the buydown, the lender can pay this fee for a higher interest rate.
The lower rate may apply for the full duration of the loan or for just the first few years. A buydown may be used to qualify a borrower who would otherwise not qualify. This is because a buydown results in lower payments which are easier to qualify for. If one does not plan to stay in a house for at least 5 to 7 years, it will be reasonable to consider an adjustable rate mortgage, a balloon mortgage or a two-step mortgage (Leggett). Adjustable rate mortgages traditionally offer lower interest rates during the early years of the loan than fixed-rate loans. A two-step mortgage generally offers a lower interest rate than a 30-year mortgage for the first 5-7 years. A balloon mortgage offers lower interest rates for shorter term financing, usually 5 or 7 years. Because of a lower interest rate, it is easy to qualify for these type of mortgages. However, one should not accept the ARM unless the maximum possible monthly payment can be afforded.
In summary, there are dozens of mortgage types and each have unique advantages and disadvantages. The choice of a particular mortgage is dependent on many factors including financial status, current economy, and degree of risk one is willing to take on (Leviton). The decision to accept a particular mortgage should be made based on reliable information and thorough understanding to avoid long-term financial problems.
Dudney, D., M.O. Peterson, and T. Zorn. "Mortgage Debt: The Good News." Journal of Financial Planning. September (2004): Article 7.