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.

A mortgage will become your biggest debt in years! For most people it is true, but it not as scary as it may sound. When you have the knowledge, when you understand what exactly is going on, when you are in full control of the situation – trust me, it is not scary!

I am here to share all the knowledge of the matter I have, with you.

We’ll start with the general idea of the most frequently used mortgage programs.

The two fundamental types of mortgages are the Fixed Rate Mortgage and the Adjustable Rate Mortgage. They both are amortized mortgages, which means that you have to repay the money you borrow (the principal) plus the interest on this money. As the name suggests, the Fixed Rate Mortgage provides the comfortable stability of a fixed interest rate – no matter what, you always know that you will not wake up one day to find out that your debt has unexpectedly doubled. If you have a stable job and your income flow is smooth and steady – this kind of mortgage can be for you. The only problem is that its Interest Rate may be higher than the Interest Rate of an Adjustable Rate Mortgage. You have to pay for the comfort, but it may be well worth it, if you don’t feel very adventurous about your finance.

An Adjustable Rate Mortgage usually looks very appealing in the beginning – the lenders use this trick to attract more customers, but later on the Rate can be changed and, as you understand, there are extremely few, if any, lenders ready to make the rate lower, so it will go up. However, the probability of you waking up to a doubled debt even with this type of mortgage is next to impossible either. There are laws and regulations about adjustable mortgage rates, protecting both the borrower and the lender. First of all, in the very beginning you can have the Rate fixed for as long as several years (the longer this period – the higher the Rate). Next is the Interest Rate Cap – the limit of the Rate increase. Moreover, the increase of the rate is not the personal whim of the lender. The rates are determined by several macro-economical indexes, which, in fact, are not controlled by the lender in any way, or by anyone at all, except for His Majesty Market.

All other types of mortgages are basically variations and derivatives of these two. The number of the variants is practically unlimited, which is good, because you will always be able to find a program to satisfy your needs and budget.

For example, an Option Adjustable Rate Mortgage adds a lot of flexibility (and complexity) to a conventional Adjustable Rate Mortgage. Every month you are given a choice of payment options: you can pay an amount equal to a period payment of, say, an interest-only mortgage with your actual interest rate, or as if your Interest Rate were 1%, or some other combination. The Interest Rate can be adjusted any month, too. This mortgage plan can be perfect for people whose income is not even all the year around. The only thing that is fixed in this mortgage plan is the minimum amount of a period payment, which, as usual, is very attractive in the beginning, but beware – it tends to increase with time and may actually result in an amount virtually impossible for you to pay.

Fixed Rate Mortgages may have an easier mechanism, but it does not mean they lack options. The most common of them is the so-called Balloon Mortgage. It’s a sort of a cross-breed of a fixed rate and an adjustable rate mortgage. On the one hand, the Period Payments are calculated on the same basis as, say, with a 30-year Fixed Rate Mortgage, but the actual “balloon” term is considerably shorter. Usually, after 5 or 7 years the Balloon Mortgage has to be completely repaid, which forces the borrower to either pay off the remainder of the balance himself at the end of this period of time or refinance at a new interest rate. The new rate, however, is not limited the way it is with an Adjustable Rate Mortgage, so you can expect literally anything. Most lenders do have common sense, though. This type of mortgage has proved to be useful to people who intend to move out of the property as the balloon period expires.

An Interest-Only Mortgage can be very helpful if you feel that actual repaying of both the amount you’ve borrowed (the principal) and the interest on it may become an unbearable burden to your budget. You may consider paying only the interest, but beware – after the 30 years of accurate repayments, the mortgaged property will not be yours! The full amount of the principal (unless you make some occasional extra payments) will still be your debt, and you’ll have to either sell your property and repay the debt or re-mortgage the property on the terms that will exist 30 years ahead from now. Most lenders, however, prefer mortgages that do get repaid, so you may find it quite tricky finding a lender ready for a complete 30-year Interest-Only Mortgage. Usually a starting period of 5 Interest-Only years is offered, but after that you will have only 25 years left to repay the Principal – the period payments will be even higher!

Quite an interesting option is the so-called Piggyback Mortgage. When buying a home, the buyer is usually required to put at least 20% of the purchase price down. Unfortunately, not every buyer is capable of doing that easily. That’s where one can count on some crucial support from a Piggyback. You mortgage 80% of your new home on the terms of your selected mortgage, and then the remainder of 20% too, as a fine addition to the major mortgage, but on different terms. You end up with actually a combination of two mortgages on the same property, with an advantage that you don’t have to put down any money of your own. This combination would make an 80/20/0 Piggyback Mortgage, i.e. 80% – your first mortgage, 20% – the secondary mortgage, 0% – your own money. Other frequently used options are 80/15/5, 80/10/10 and 80/5/15.