How can you overcome the risks associated with an ARM?

A borrower opting for an adjustable rate mortgage (ARM) often comes across risks such as payment shocks and negative amortization.

• Payment Shock:
  Payment Shock occurs if the monthly payment goes up sharply at the first rate adjustment. In order to protect you from ever-increasing rates and payments, rate caps are applied which prevent the rates and hence monthly payments from rising beyond a certain limit. Generally, there are periodic rate caps (for the adjustment period) and lifetime rate caps (for the life of the loan).
  
  In addition to interest rate caps, the ARMs provide payment caps which restrict the payments from going beyond a certain level. Thus, even if the rates go up, the payments may not increase proportionately due to the presence of payment caps.
  
  
• Negative Amortization:
  While the payment cap limits the rise in your monthly payments, the payments are not large enough to cover the interest due each month. The unpaid amount of interest is then added to the loan balance which thus increases thereby increasing the debt. This is known as negative amortization. However, there are certain loans which offer a cap on negative amortization that limits the total amount owed to 125% of the loan amount.

If you have applied for an ARM and your financial situation changes, you may decide not to take over the risks in the loan. In that case, you may think of prepaying the loan. But the lender may require you to pay a prepayment penalty. Alternatively, you can convert to a fixed rate loan at the prevailing market rates, but this is possible only if your loan agreement provides for such a clause.

Related Readings:

• Why and When to go for an ARM?
  
• How do the ARMs work?
  
• What does Negative Amortization imply?