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.

Once I googled for Option ARM and the top search result read Nightmare Mortgages. Very … hmmm … intriguing, isn’t it?

Well, as I always say, you have to have a clear idea of how a mortgage plan works. Once you are sure, that you understand it, you can decide for yourself, whether such an Option is likely to become your nightmare.

The Option Adjustable Rate Mortgage offers the borrower several options for each monthly payment. The mortgage contract states what exactly variants are possible. The first one or two months, depending on the contract, the borrower is entitled to a very low interest rate and a very low period payment amount. When this introductory period expires, the rate goes up and each period payment is paid according to the selected option. The usual available options are: a minimum payment, or an interest-only on a 30-year mortgage payment, or a fully amortizing 30-year mortgage payment, or a fully amortizing 15-year mortgage payment. That means that one month you can pay only the interest and the next monthly payment may equal to a monthly payment of a 30-year Adjustable Rate Mortgage with your balance and the rate of the day. If you choose the minimum payment option, which is a really low amount – just imagine what you can do with the “saved” money!!! Where’s the nightmare, you say? Well, it is already there, but it is not obvious yet, that’s why a lot of people make a mistake and agree to these terms without reading the fine print thoroughly. The word “saved” is in quotes only when you read it, not when you hear the broker say it…

Option Adjustable Rate Mortgages have been on the market since the early 1980′s. Originally created for quite well-to-do people, they provided the versatile flexibility of early payments and caused no problems later, when the payments increased. In the course of time, the instability of the real estate market made the traditionally popular Fixed Rate Mortgages unaffordable to many families. Banks started looking for alternatives and here came Their Knight in Shiny Armor – Option Adjustable Rate Mortgage to All. The only problem with it was (and still is) that brokers, for the reasons of their own, did not always bother to explain every detail of the deal to their customers. Sad, but true. Unaware people found themselves trapped in a debt they could barely (if at all) pay off.

So, what’s the big picture?

First of all, the Option Adjustable Rate Mortgage is an Adjustable Rate Mortgage, i.e. after the first month or two of the super low teaser rate, the rates start to be generated in a regular way from the selected index plus the margin. The first month is usually the bait (excuse my language). The broker offers his customer an Interest Rate of around 1.5%, as opposed to the average of, say, 6.5% for a Fixed Rate Mortgage, and a very low fixed amount as the minimum period payment. Chocolates and cakes…. Fascinating, isn’t it? That’s just the right moment to realize, that free cheese, chocolates and cakes, are only found in a mousetrap.

The Option Adjustable Rate Mortgage is a monthly adjustable mortgage with no adjustment caps. The only constraint is the top limit of the rate allowed during the whole life of the loan and the margin. Hypothetically, the interest rate on your loan can jump from 1.5% to 12% in one month! Luckily, most Option Adjustable Rate Mortgages stick to the rules of conventional Adjustable Rate Mortgages and use indexes and margins to derive the rates. The rate catches up with the market already in month two (sometimes three) and you should immediately reconsider the option of your monthly payment. If you stick mechanically to the minimum payment established at the mortgage origination, you can get yourself into a big trouble. The minimum monthly payments can be raised by only 7.5% a year – that’s the payment cap with most Option ARMs. Thus, the initial period minimum payment amount calculated from the super low introductory rate, will be fixed as your option of the minimum payment for at least a year, while the rate will continue to rise. Normally, a period payment should be able to both amortize some of the principal and pay the interest. If you choose to pay the minimum only, it may (and very likely will) so happen that the amount will be too low to accomplish this purpose. It will cover the principal part of the payment, but fail to pay most of the increased interest. All the sums of the underpaid interest will be added to the balance! The overall balance will increase – instead of paying the loan down you’ll be underpaying it up! Already after one year, when you get your first chance to adjust your minimum payments, you’ll have to deal with a debt bigger than your original loan. This situation is known as negative amortization. Not pretty!

Negative amortization is not an endless process that builds up your debt to 1000%. It strikes sooner. Most Option Adjustable Rate Mortgages have a negative amortization cap of 110 percent to 125 percent of the original loan amount. When the mortgage balance hits this bar, the mortgage minimum payment gets “recast” – it is raised to the amount sufficient to pay off the loan within the remaining term. Taking into account the increased balance, you literally have to face a bigger loan with a shorter term. The minimum payment imposed upon you by the bank from that point on will be a lot higher. A payment shock.

Now. There there. Take a deep breath. You must be wondering why people go for it anyway? Two reasons, I’d say – unawareness and sound knowledge. In the former case, under-informed borrowers get themselves into trouble with the minimum payments; in the latter case, people know how to avoid the unnecessary risks and feel sure of their, pretty much their own, payment plan.

A few words about how to join this jollier club.

First of all, never forget that it is an Adjustable Rate Mortgage. If you really intend to pay it off, let it stay that way and choose either the 30-year or the 15-year period payment as your monthly payment option. These payments do amortize your loan. They make your Option Adjustable Rate Mortgage pretty much similar to the conventional Adjustable Rate Mortgage, with a little bit of some very limited freedom to pay less (the minimum payment or Interest-Only) from time to time to clear yourself some extra cash for other urgent needs. With a good calculator you can estimate how many minimum payments and how often you can afford.

Minimum payments are subject to recast every 5 or 10 years regardless of the fact whether the negative amortization cap has been reached or not. People who pay only the minimum, actually race against time: what will happen first – will the negative amortization cap be reached and they get recast payments or will 5 years manage to elapse before it happens?  Even if somewhere halfway these borrowers realize what is going on, there is little they can do. Steep penalties prevent them from refinancing.

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.