November 22, 2004

Adjustable rate mortgages (ARMs) have always been a hard sell. ARMs have multiple features, which makes them complicated, and complexity doesn’t sell well.

Most loan officers try to avoid complexities by focusing on one feature that may attract the client’s interest; this is the "hook". ARM hooks are almost always mortgage payments that are relatively "low", or "stable", or "interest-only".

When more persistent borrowers ask questions about the implications of low, stable or interest-only payments, the response may be an "artful deception." The loan officer makes a correct statement about the ARM, from which the client is allowed to draw an erroneous conclusion without being corrected. The letter below illustrates one of the more common artful deceptions.

"I am interested in an adjustable rate mortgage (ARM) because it has a really low payment, but it does allow negative amortization. When I asked the loan officer about this, he said that negative amortization was limited to only 10% of the loan amount."

Negative amortization arises when the mortgage payment is smaller than the interest due, with the difference added to the loan balance. For example, if the interest due in month 1 on a $100,000 ARM is $600 but the payment is only $500, the balance in month 2 goes to $100,100.

Since all mortgages must pay off over their term, the balance on a negative amortization ARM must stop rising at some point and start declining. And this means that at some point the payment must increase to a level that will repay the balance over the period remaining to term.

To make sure that this happens, contracts covering ARMs that allow negative amortization contain a negative amortization cap. The cap limits the amount of negative amortization to some percent of the original loan, usually 10% or 15%. If the cap is 10%, for example, the balance on a $100,000 loan cannot exceed $110,000.

Borrowers informed about a negative amortization cap are allowed to think that it protects them in some way. Perhaps they will assume that the lender will forgive the interest that is not covered by the payment?

Not a chance! Negative amortization caps are designed to protect the lender, not the borrower. When the balance reaches the maximum, the payment is immediately raised to the fully amortizing amount – the payment that will pay off the loan over the period remaining -- regardless of how large an increase that might be. The payment adjustment cap, which usually limits the size of any payment increase to 7.5% per year, is contractually overruled if the balance hits the negative amortization cap.

A negative amortization cap thus provides no reassurance at all to a borrower contemplating a negative amortization ARM. What the borrower should want to know is how large the payment increase might be in the event that the negative amortization maximum is reached. Unfortunately, very few loan providers have the inclination or the capacity to answer this question.

"I have been offered an ARM at 2.5% that is interest-only for 5 years. It sounds too good to be true…"

This letter illustrates another artful deception used to market ARMs. The borrower considers the offer too good to be true because she believes that she will have the 2.5% rate for 5 years. In fact, the quoted rate held only for the first month.

The loan officer didn’t tell the borrower that the 2.5% rate held for 5 years. The borrower assumed erroneously that the interest-only period and the initial rate period were the same, and nobody corrected her mistake – until she wrote me.

The purpose of this article is not to dissuade anyone from selecting an ARM. The lower payments on ARMs in the early years are attractive, provided that borrowers can handle the risk of payment increases later on. ARMs that allow negative amortization provide the lowest payments early on, and also the greatest risk of future payment shock.

The problem is that very few loan providers offer any information bearing on how large the risk is. The prevailing view is that any mention of risk is a downer that is going to discourage sales. Borrowers must do their own risk assessment.

Here’s how. Print out Information to Evaluate an Adjustable Rate Mortgage. Have the loan officer fill it out for each ARM you are considering. Then use my calculator 7c if it allows negative amortization, 7ci if it allows negative amortization and has flexible payment options, or 7b if it is a no-negative amortization loan. These calculators will allow you to see what would happen to the payment under different assumptions about future interest rates.