Adjustable rate mortgages are a good option for many people who want to buy a home. Fewer borrowers know that these loans can cause problems with negative amortisation.
Adjustable Rate Mortgages
A lot of people get mortgages with rates that can change over time. The reason for this is that the interest rate on these loans is usually much lower at the start than with fixed rate loans. So, people with adjustable rate mortgages can buy homes they might not be able to afford with a fixed rate mortgage.
Everyone knows that mortgages with rates that can go up or down pose a risk. A borrower runs the risk that interest rates will go up over time, which could make it hard for them to pay their mortgage each month if the rates go up. If the interest rates and payments go up too much, the borrower may have trouble making payments and may even lose the house.
Many lenders use caps on rate increases to get people to buy homes so they don't have to worry about rates going up. These caps limit how much the monthly payment can go up over a certain period of time. For many loans, the term is one year and the rate increase is one percentage point. This makes borrowers feel safer, but lenders don't tell them one important thing.
Amortization that goes down
On many mortgages with an adjustable rate, the caps only affect the monthly payments. The caps don't affect the interest rate that is actually being charged on the loan. This leads to a financial disaster because even though you are making your monthly payments, the principal of your loan is going up. This is called negative amortisation, and you should do everything you can to avoid it.
The best way to explain negative amortisation is with a good old credit card. If you have a credit card debit, which everyone does, you know that making the minimum monthly payment may not make much of a dent in the total balance. In fact, it might be less than the interest charged for the month. This becomes clear when you get your next bill and see that your balance has gone up. Negative amortisation is a new world for you.
If you have a mortgage that changes over time, you need to read the fine print to fully understand how any caps affect your loan. Try to avoid negative amortisation as much as possible, no matter what you do.
