As the mortgage meltdown continues in full swing, many borrowers are faced with payment adjustments that they thought they could simply refinance out of... Turns out they were wrong. It is almost impossible to refinance out of bad adjustable rate mortgages right now. The result is that payments are adjusting to the maximums permitted under the mortage note. In the worst case of negative amortization loans, the mortgage recasts to a fully amortizing amount forcing the borrower into immediate foreclosure.

Here's the skinny about the Maximum House Payment Adjustment

The first thing to understand about these tricky mortgages is that you have to keep your eye on two different balls (as opposed to traditional mortgages). In most Adjustable Rate Mortgages, including the Interest Only Loan and the Pay Option ARM, there are two changes that can happen at any given point in time: (1) the rate can change, and (2) the payment can change. Keep in mind that either of these can happen irrespective of the other one. A payment change doesn't necessarily mean the rate changed, and a rate change does not mean the payment will change.

The upfront rate on ARMs (sometimes called a "teaser" rate) is usually lower than the rate on a comparable fixed rate mortgage. This, in turn, means that initial payments will be lower as well. Borrowers can qualify for a larger loan amount with an ARM than they can for a fixed-rate mortgage.

This feature allows for two basic types of ARM borrowers: (1) speculators, and (2) borrowers that need ARMs to qualify. In most housing market crashes in the past, only the speculators (who were highly leveraged) had problems meeting their minimum payments. Unfortunately, the explosion of these mortgages (especially in the California mortgage market) combined with the current credit implosion has given borrowers in both categories few options.

Understanding ARMS - The Fixed Rate Term

There are two terms during the course of an ARM loan. In the first term, the payment and the rate are usually fixed. (In a traditional mortgage the rate is fixed for the entire term of the loan.) ARM loans allow for a shorter term fixed period at the beginning of the loan. As the loan matures, both the payment and the rate will inevitably increase.

Here's where it gets sticky. The initial fixed period had been 5 to 10 years in the past. Beginning in the mid 90's (and exploding in the 2000's) the initial period available dropped. In some cases, the initial period is as short as one month until the first rate adjustment. This is why they call it a "teaster" rate.

Now we go from sticky to ugly. Remember that a rate change doesn't mean a payment change. So, for the first month the payment and the rate are both based on - say - 1.95% (A popular rate for the first month of California Pay Option ARMS). After that, the rate could adjust up limited only by a periodic cap - so the actual rate could have gone up to say 5.95%. The payment, however, remains fixed at the 1.95% amount for the first year. You can guess what happens to the 4% spread for the next 11 months: Negative Amortization occurs and the shortfall is added to the principal balance of the loan.

How are Rate Adjustments Determined?

The ARM's rate after the initial rate period ends will be the sum of a specified interest rate index, plus a margin (both identified in the Note). This rate is called the "fully indexed rate."

The amount at which the rate can change is usually limited by rate adjustment caps. These caps provide a limit to the amount by wich the interest rate may increase. Generally, these rate adjustment caps are 1% or 2% PER RATE ADJUSTMENT.(So the rate can keep ratcheting up and up and up.)

The second limit specified in the note will be an overall life cap rate. This rate defines the maximum allowable rate on the ARM loan. This maximum rate is usually 5 or 6 percent more than the initial rate.

There can be (and often are) multiple rate adjustments during the course of a typical ARM loan. All rate adjustments after the initial rate adjustment are called "Subsequent Rate Adjustments." The duration or term of the subsequent rate adjustments are usually not the same as the initial rate period. These terms were often identified by the product name. For instance, a "3/1 ARM" means that the initial period is three years followed by a yearly rate adjustment. Subsequent rate adjustments are subject to the same caps as the first rate adjustment.

Negative Amortization

As you've seen, it's easy for borrowers to become subject to Negative Amortization. This usually happens as discussed above - when the rate changes more frequently that the payment.

However, even if the rate and the payment change at the same time, there may be a "payment cap" (usually 7.5%) that limits the amount by which the overall payment can change. In this case a large rate increase may result in negative amortization.

Maximum Negative Balance

In loans that allow for negative amortization, there is always a Maximum Negative Balance defined that limits the overall amount of the principal balance. This is usually defined as 110% or 115% of the original loan amount (some loans have been as high as 125%, but those are rare). This number is the scariest number for the borrower. When the principal balance hits that amount, the loan will recast to a fully amortizing loan immediately and the payments will skyrocket.