The second problem is that the loan will be recast periodically, commonly every five years. Recasting means that the payment is adjusted to fully amortize the loan in the remaining time of the term. This recasting clause also supersedes the yearly payment cap and adjusts the payment to whatever is necessary to pay off the loan in the remaining term. What is the answer? It is the same old story of common sense. If the start rate and initial monthly payment are far below prevailing rates and the payment amount necessary to amortize the loan amount in the agreed-upon term, be careful. You know how much you are borrowing. You know the real interest rate that you will have to pay (the index plus the margin). You know how many years you have to pay it off (the term).
What does common sense tell you? The less you pay in the early years of the loan, the more you will have to pay later.
It also tells you that the smaller the payment, the less will go to principal. This means that you will pay much more interest than in the price of the early smaller payments. Studies done on these loans show increases in the monthly payment well over 100%, even if the index rises only slightly. The higher the margin and the lower the start rate, the greater the payment increase. It has been suggested that lenders should be required to raise the start rate based on their margins. A lender with a 4% margin would be required to have a higher start rate compared to a lender with a 2% margin. This would narrow the gap between the initial required payment and the adjusted payment if maximum negative amortization occurs, or when the loan is recast. However, there is currently no law or regulation requiring lenders to do this. Again, the time element is very important. If your income does not allow for a standard payment, interest rates are high and are expected to fall, housing prices are on the rise, and you plan to sell the home within five years, this may be a great loan. Unfortunately, most of these ifs are unpredictable.
The smarter way is to work out a somewhat pessimistic scenario of the possibilities. If you believe you can survive the worst case and the only loan that will allow you to buy the house is one with a low start rate and high margin, you are at least making an informed decision.
It is not difficult to avoid payment shock. Some simple figuring on your own will tell you what to expect. As a result, you will be less likely to get caught in the trap of deciding if this type of loan is good for you.