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Does Negative Amortization Decrease Equity Over Time?

Original post by Daria Kelly Uhlig of Demand Media

Cash-strapped consumers are often tempted by mortgage loans from lenders promising rock-bottom rates or ultra-low monthly payments. Although initial interest rates and payments are important considerations, they don't tell the whole story. It's important to consider the long-term consequences of your mortgage as well. That's especially true of negative-amortizing loans, a type of adjustable rate mortgage that can have a devastating effect on your equity, and on your future payment amounts.

Background

Negative-amortization adjustable rate mortgage (ARM) loans originated in the 1980s. High fixed rates prompted schemes like payment caps that kept monthly payments low. The caps were so low that borrowers' monthly payments failed to cover the interest accruals. Lenders added the shortfalls to the loan principals, resulting in ever-increasing principal balances. Complicating matters was an increase in the index used to set adjustable mortgage rates. Higher rates and higher balances created a perfect storm that left many homeowners underwater.

Option ARM

The modern version of the 1980s-style negative amortization loan is the option ARM. During the first years of the loan, you can make the standard principal and interest payment, an interest-only payment or a minimum payment that may be less than you need to cover accrued interest. The unpaid interest is added to your principal balance, and the payment amount adjusts each year. The interest rate adjusts at the end of the option period, which often lasts five years. The rate then resets at a level determined by market conditions and you'll begin making regular principal and interest payments.

Benefits of the Option ARM

An option ARM may be appropriate for some borrowers. You may benefit from the ability to make low payments if your income is unpredictable. The option ARM might also serve as leverage if you're an investor who prefers to maintain higher cash flow. Alternatively, if you intend to sell your home before the rate readjusts, you can choose an option ARM if you're confident your home will sell in time.

Risks of an Option ARM

An option ARM creates a negative-amortization situation from the onset if you make only minimum payments. Rather than pay down your loan balance, you'll add to it. And you'll reduce your equity in the process. If you fail to cover the interest accrual, at the very least, you'll eventually find yourself with negative equity, and you'll owe more than your home is worth. Ultimately, yearly payment adjustments coupled with the potentially large rate adjustment at the end of the option period can saddle you with an impossibly large payment on a home that negative equity prevents you from selling. Even if you make interest-only payments that cover accrued interest, the shortened repayment period after the option period ends can lead to unexpectedly high payments. A five-year option period on a 30-year mortgage, for example, leaves just 25 years to repay the full principal amount.

                   

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About the Author

Daria Kelly Uhlig began writing professionally for websites in 2008. She is a real-estate agent and a blogger and has held a variety of editorial positions, most recently as a contributor to the "Oxford English Dictionary." She holds an associate degree in communications from Centenary College.

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