This Week's Q & A

Q: Are there any legal limits on the amount of negative amortization lenders can build into a loan?

A: No, but I can think of a lot of good reasons for avoiding loans of this type. Negative amortization occurs when the monthly payments you make on a loan are not large enough to repay the entire principal balance by the end of the loan term. You saw loans structured in this way more often when mortgage rates were much higher than they are today, as lenders tried to expand the pool of borrowers who could qualify for financing.

One solution was to offer deeply discounted adjustable rate loans with caps limiting the dollar amount of the increase permitted at each adjustment, but no limits on the size of the adjustments allowed. To illustrate, let’s say the one-year ARM rate is 9 percent, which it was several years ago. Because you can’t qualify for a 9 percent mortgage, the lender offers to discount that initial rate to 7 percent, which you can afford. At the end of the first year, the index to which your ARM is linked has increased by one point, which means your loan rate should jump to 10 percent – first to the starting rate of 9 percent (because that 2 percent discount lasted only for one year) and then another one percent, to reflect the increase in the index.

Anticipating, wisely, that you probably wouldn’t be able to absorb a huge increase in your monthly payments, the lender has also limited the amount by which your monthly payments can increase at each adjustment. So instead of jumping by $250/month, your payment will increase by only $50 – painful, but not fatal. (These numbers aren’t related to anything; I’m just trying to keep the example simple.)

What about the $200 difference? The lender isn’t going to forget about it; that amount will be tacked on to the principal balance of your loan. So instead of declining as you make your monthly payments, your outstanding balance actually grows. That’s not a pleasant sensation, and it could add up to a nasty and expensive surprise when you think you’ve made the last payment on your mortgage, or when you get ready to sell your house, and discover that you still owe as much, and possibly more, than you borrowed originally.

If you’re having trouble qualifying for a mortgage, there are several alternatives you might consider. Buying a less expensive house that requires a smaller loan is one possibility; a below-market loan program designed for first-time buyers may be another. But a mortgage that creates negative amortization shouldn’t be anyone’s first choice, and I’m not sure it should be on the list of choices at all.