I can think of three reasons for that. One of them or any combination of them could result in such an illogical at first glance situation:
• You made an extra payment towards the principal some time ago and now it’s taking effect. The balance has become so low, that even a higher rate cannot push the actual sum of the monthly payment to its previous margin.
• The PMI got cancelled by the lender. Under the provision of the 1999 Federal law, lenders are required to cancel private mortgage insurance on most home mortgage loans made after July 29, 1999 automatically when amortization has reduced the loan balance to 78% of the value of the property at the time the loan was made. An earlier cancellation at 80% of the property’s value is likely to happen only if initiated by the borrower himself.
• If the rate has increased, but the amount of your monthly payment remained unchanged or went up insignificantly and then froze at that level, you may be in trouble, because these are the symptoms of a monthly payment cap in action. Check your mortgage contract: Is your mortgage an adjustable rate mortgage? Does it carry a payment cap? If this is the case, you should immediately look for ways to avoid negative amortization, and fast, before it increases the outstanding balance of your mortgage and wastes a lot of the effort you have put into paying the debt off.

This very unpleasant situation is called negative amortization. The most likely causes are:
i) You have an adjustable rate mortgage with a payment cap that does not allow you to raise your monthly payment enough to match the new interest rate. As a result, your monthly payment is probably high enough to cover the principal part and some of the interest, but all the underpaid interest is added to the outstanding balance. The situation calls for emergency action!!!
ii) You have an option adjustable rate mortgage and you stick to the minimum payment option, even though the rate has changed. If you have ignored the raised rate for 2 years you are in big trouble, because most option ARMs carry a 7.5% a year minimum payment cap. Under such a limitation it is very problematic to catch up with the new rate and the debt it has already produced. The only way out of this is selecting some other option for your monthly payments immediately; otherwise negative amortization can increase your debt to a virtually unpayable amount.

This very unpleasant situation does require a considerable financial effort on your part, but it can be resolved eventually to your advantage. The two most reliable ways are: to make extra payments towards the Principal, or/and refinance into a Fixed Rate Mortgage.

How do extra payments help? The amount paid as Interest is a percentage of the outstanding balance (the principal part). The lower the balance – the lower the absolute interest payment. If your mortgage carries no principal prepayment penalties, you can pay some extra cash towards the principal. It may keep the absolute sum of your monthly interest payment close to intact on the one hand, and it will accelerate the overall payoff of the mortgage on the other. So none of your money will be wasted, but you may have to tighten your belt for a while.

Refinancing into a Fixed Rate Mortgage is not cheap either, so before you decide to turn to the stability of a fixed rate, analyze your current mortgage – make sure the change is worth it. Points to consider:

• a convertible loan feature that allows for an easier conversion of an Adjustable Rate Mortgage into a Fixed Rate Mortgage may already be included into your current contract.
• Compare the cost of refinancing with the gain on the saved interest.
• Your current adjustable rate mortgage very likely carries all kinds of caps. You have to see how they limit the rate and how much higher it can possibly get. It may well so happen that your highest rate will still be lower than the fixed rate.
• Watch out for the Payment Cap as the rates rise! Make sure it is not amortizing your mortgage negatively! If it is – refinance immediately into anything you can afford, before it brings your current balance to the size far beyond your financial potential!

 It’s amazing how surprised people usually are to find out how much an extra $20 payment may save them on their loan in the long run. For example, a $100,000 30-year mortgage bearing 9 percent annual interest calls for monthly payments of $804.62. Suppose a borrower could afford to increase the payment amount by $20 to $824.62, and the lender does not charge prepayment penalties. By making the larger payment each month, the borrower would save $24,135.56. No, you didn’t misread the amount. An extra $20 a month results in roughly $24,000 of interest savings!

Here is our little manual on how to work your own miracle.

First of all, the topic you absolutely must discuss with your mortgage lender is the treatment of extra payments towards principal, because some lenders tend to include a penalty clause regarding extra principal payments in the mortgage. If your credit score is not particularly high, you will very likely have a mortgage loan with a higher-than-average interest rate, and you may be penalized if you try to make extra or early principal payments on the loan.

If your lender allows you to make extra payments – it is action time! Get a good on-line calculator (or download a more universal one from here) and take a look at the amazing amount of money you can save by simply making one extra payment a year, or by altering the pace at which you make your payments. A fine example is a biweekly mortgage. Well, not so much the biweekly itself, but its rival and equally efficient alternatives based on conventional mortgage loans and extra payments towards them.

I will not tire you with more numbers and examples here, you can marvel at the sums and the savings the calculator reveals to you yourself. I will only try to explain how these things can be accomplished, assuming your mortgage carries no principal extra payment penalties.

If you have a Fixed Rate Mortgage, the amount of your monthly payment is fixed throughout the life of your loan. Extra payments towards the principal make such a loan amortize sooner altogether, but they do not affect the amount of your monthly payment, they only change its structure. Let me remind you, that each Fixed Rate Mortgage monthly payment includes a certain amount that pays the interest and the rest goes to the repayment of the principal. Even though the total amount is fixed, the proportion of these two elements can and does change. Once you’ve paid something extra towards the principal, it decreases, which means that the amount of interest due with the next payment is lower, which, in its turn, means that the principal/interest balance of the monthly payment will shift: the amount paid towards interest will become smaller, which leaves more money to be paid towards principal. More to the principal > next payment’s interest part shrinks > more to the principal. This, by the way, is the natural scheme of a Fixed Rate Mortgage repayment plan, but extra payments always give it a neat boost – things move faster and the loan’s balance hits zero a lot sooner, if you cared to pay sound (I certainly don’t mean huge!) regular extra amounts. If your loan gets to be amortized in 24 years rather than the original 30, you realize how much the 6 avoided years of interest payments just saved you.

With an Adjustable Rate Mortgage, however, you will find that extra payments do affect the amount of your monthly payment. The period payment gets recalculated on the new principal and adjusted to the new rate on the rate adjustment day, stated in the contract. If your Adjustable Rate Mortgage has an initial, say, 5-year period of fixed rate, even with extra payments made during this period, the monthly payment will remain unchanged till the first rate adjustment.

The only type of mortgage whose monthly payment responds to an extra payment practically immediately is an Interest-Only Mortgage. Or so it should be. A lot of borrowers, however, complain that in reality this does not seem to be the case. Some lenders find it too much bother recalculating the payment every month, so they wait until an anniversary month to apply all the changes. Well, it is not bad either, and in month 13 (the anniversary month) you may be pleasantly surprised to see the adjusted amount of your monthly interest-only payment – since the interest due has been lower all since the extra payment(s), a part of the monthly payment has been credited to the principal. Still, if your goal is to have your payment decrease straight away – ask for this feature explicitly.

Thus, two main things to consider when deciding for an extra payment:

• Make sure there is no penalty for extra payments towards the principal;
• Find out about alternative investments – interest rate, taxes.

Let me explain the second one. Your loan’s interest rate is the key to how much extra payments can save you. Actually, any investment’s interest rate is the key to how much return you can have on your money. So, you may want to try and find some other than the mortgage option(s) to invest the money into and gain a better return. It may so happen that you own a business and the money invested into it will return 15% as opposed to, say, 9% of your mortgage interest rate. Or a bank deposit can sometimes have an interest rate higher than the rate of your mortgage. Investments with a higher rate of return look immediately more attractive, and can, in fact, be more profitable, but the tricky thing to always bear in mind is the tax deductibility of the mortgage interest payments as compared to the other option’s relationship with taxes.

The Adjustable Rate Mortgage does not seem to be very attractive to borrowers mostly because of the apparent complexity of its mechanism. When people hear about market indexes, constantly increasing rates and negative amortization, they don’t want to listen to this any more and just go for the good old Fixed Rate Mortgage. Before you follow their easy steps too, consider reading at least this article and make your final choice based on some knowledge, not on the lack of any desire to deal with anything more complicated than a fixed amount to pay every month.

Now, get yourself a cup of good coffee and prepare to learn about market indexes, increasing interest rates and negative amortization.

What’s the most important thing to remember about the Adjustable Rate Mortgage? Well, naturally, that the Interest Rate gets adjusted a number of times within the life of the mortgage, but – now comes the most important thing – it can increase (or decrease) only to the limit specified in your mortgage contract! That means that the lender is not totally free to impose any rate on you any time of the day. That’s the good news. The bad news is, however, that any Adjustable Rate Mortgage is dependant of the free market economy. Specifically, the Interest Rate is determined by one of the several market-related indexes:

• the one-year, three-year and ten-year Treasury bill rates;
• the Eleventh District Federal Home Loan Bank cost of funds;
• the national average contract interest rate on conventional home loans;
• the national median cost of funds to federally insured savings institutions;
• the new CD-ARMs by Fannie Mae tied to the average certificate of deposit interest rate; and
• the London Interbank (LIBOR) interest rates.

There are a lot more of them, but these are the most frequently used ones. If you go for an Adjustable Rate Mortgage you’ll have to select one index to tie your mortgage to. The Interest Rate of your mortgage will be derived from the Rate of the index on the day closest to the adjustment day. You may find it quite useful to study the history of the indexes’ dynamics before you decide on the one to base your mortgage upon. The data is widely available in papers and on the Web. Fannie Mae requires that the frequency of rate changes should match the index selected. Thus, the one-year Treasury index is used to adjust the one-year Adjustable Rate Mortgage, while the three-year Treasury index is used to vary the three-year adjustable loan.

Why am I not saying that your Interest Rate will be the same as the index? That’s because it won’t. Lenders have a nice consolation prize for themselves – the margin. The margins usually vary between 1.5 and 3 percentage points, and give the lender a chance to add another, say, 2% to the rate of the index. And that’s how the actual Interest Rate of your mortgage is calculated on each adjustment.

Now, some more good news is that there is a variety of protective features that you can include into your mortgage contract to make sure, that the Interest on your loan should stay within the boundaries of reason.

First of all, the initial interest rate on an Adjustable Rate Mortgage is usually considerably lower than on a Fixed Rate Mortgage. This rate usually holds for some time – the Initial Fixed Rate Phase. This period can last from one month to several years. The longer the period – the higher the initial rate.

Then the adjustment day comes. Adjustments take place as often as specified in the mortgage contract. After the initial period of a fixed rate – say, 5 years – there usually are annual adjustments. 25 years of constant interest increase may sound very scary if you have a 30-year mortgage. To avoid turning your Adjustable Rate Mortgage into a golden Adjustable Rate Mortgage, the following limitations can be included into your contract – the Interest Rate Cap and the Payment Cap.

The Interest Rate Caps can be of two types: limiting the period increase (or decrease) of the Rate and limiting the overall life-of-the-loan Rate increase (decrease). You can include one of them or both into your contract. The period rate caps vary from lender to lender and usually range from 1 to 2 percentage points. The overall rate cap is usually 6%. The overall rate cap can be represented in the contract as the maximum allowed increase of the initial rate or as an absolute value – the percent, above which the Interest Rate cannot go.

The Payment Cap is a little bit tricky. On the one hand it ensures that the lender will not demand an unreasonably high period payment, which is good. On the other hand, under certain circumstances, it can bring you to face the unpleasantness of negative amortization of the loan. These are the issues to keep in mind:

• Some Adjustable Rate Mortgages set the initial payment below the interest payment. For 5 years you may enjoy quite low period payments that, in fact, do not cover even the period Interest costs. Every underpaid penny adds to the balance of the loan, i.e. generates negative amortization. When the Fixed Rate period is over, you realize that your debt has actually increased!
• It may so happen that Rate Adjustments will be more frequent than Payment Adjustments. The Rate increased, you won’t be able to increase your payments to match it until the next allowed payment adjustment. All the period in between these two adjustments the underpayments add to the balance.
• Payment adjustment caps limit the size of the change in payment, regardless of the size of the change in Rate. Any large rate increase will result in negative amortization.

In general, I believe, that Interest Caps are a lot more sensible for a borrower than Payment Caps. One thing for sure – Interest Caps do not amortize your loan negatively!

And the last (but not least) thing to remember – most Adjustable Rate loans do not need to include a prepayment penalty. Without this penalty, a borrower can more easily refinance to a Fixed Rate Mortgage. Some lenders also include a convertible loan feature that allows an Adjustable Rate Mortgage to be changed to a Fixed Rate Mortgage after the initial adjustment periods have been completed.

A comprehensive ARM calculator can be downloaded from here.