A lender may suggest a flexible payment adjustable rate mortgage, which limits the payment increase in order to ease the borrower’s fears. The flexible payment aspect of the loan looks like a solution to the problem. The typical loan of this type will call for a payment adjustment of no more than 7.5% per year, based on the start rate payment. However, there are two problems with this loan for the borrower.
First, the increased payment will usually not be enough to cover interest only (negative amortization). This is especially true in a market in which the index rate is rising. Remember, the margin is part of the interest rate. A high margin will cause negative amortization even if the index rate is stable or falls slightly.
In flexible payment adjustable rate mortgages, there is a clause that states that if the negative amortization reaches a certain level, usually no more than 125% of the original loan amount, the payment will be adjusted to amortize the loan, superseding the payment cap. Since you owe more than you originally borrowed and have less time to pay it off, the payment will be even higher than if you originally agreed to fully amortize the loan over the original loan term.