Annual Payment Cap

The Annual Payment Cap refers to the amount your payment may increase or decrease yearly. The vast majority of Option ARM's have a 7.5% payment cap. This means the most your payment can increase or decrease is by 7.5% of the previous year's payment.

Returning to our illustration, the first year's payment is $643.28. Effective with the 13th payment, the lender attempts to recalculate the payment to achieve a fully amortizing loan subject to the payment cap. What that means is the lender projects what the principal balance will be with the 13th payment (it is necessary to estimate due to the federal requirement of the lender providing the notice of the payment adjustment 45 to 60 days prior to the effective date), uses the interest rate in effect at that time (remember, index plus margin) and attempts to re-amortize the loan over the remaining term (being 348 months left after the first year). However, the payment can not increase by more than 7.5% of the previous year's payment. So, beginning with the 13th payment, the payment will increase to $691.52 ($643.28 x 1.075%).

The 7.5% payment cap is not applicable under two circumstances:

1. When the principal balance hits the maximum amount of negative amortization. Should that event occur, the loan will be recast subject to the principal balance at that time, the interest rate in effect at that time, and the remaining term on the loan. Let's say, for example, the loan hits the maximum amount of negative amortization with the 42nd payment and let's use a fully indexed rate of 6.5%. Given these parameters:

a) Principal balance equals $220,000 (original loan amount of $200,000 multiplied by 110%)
b) An interest rate of 6.5% (estimate of the margin plus the index value at
that time)
c) A remaining term of 319 months (original term of 360 less the 41 payments already made)

the new payment would be $1,450.57! That's a big ouch since your payment history looked like this:

Payments 01 - 12 $643.28
Payments 13 - 24 $691.52 (7.5% of the previous year's payment)
Payments 25 - 36 $743.39 (7.5% of the previous year's payment)
Payments 37 - 41 $799.14 (7.5% of the previous year's payment)
Payments 42 - 48 $1,450.57

When your loan hits the maximum amount of negative amortization is a function of what payment you have been making, e.g,. the minimum payment, the interest-only payment or a fully amortizing payment. Naturally, the less negative amortization you accrue, the less your payment will increase. Another important factor is the interest rate, of course. Rising rates and minimum payments will accelerate the amount of negative amortization accuring. Decreasing interest rates will help to defray negative amortization.

Once your payment approaches a fully amortized payment, you will then begin to experience payment decreases as well. Yes, it can happen! When I purchased my home, I selected the Option ARM for my loan program. At that time, deep discounted initial start rates were not available. The initial start rate was about 1% to 2% less than a 30-year fixed rate mortgage. Right after I purchased my home, rates began to decrease -- each and every month. When my first payment adjustment came up, I actually hit my payment cap on the downside! What that means is that because my payment could only decrease by 7.5%, I was making more than the fully amortized payment. Consequently, I had an extra $200-$350 being applied to my principal each month! My principal reduction was actually accelerated!

2. The next situation in which the payment cap is eliminated is every 5th year of the loan term. These adjustments are built into the loan program. With the 60th, 120th, 180th, 240th and 300th payments, the lender recasts the loan (again, takes the principal balance and effective interest rate at that time and re-amortizes the loan over the remaining term). These recasts must be done periodically to achieve a fully amortizing loan as the loan must be paid in full after 30 years (or the end of the original loan term, e.g., 15, 30 or 40, whatever it may be).