What potential issue may arise due to payment caps on an adjustable rate mortgage?

What potential issue may arise due to payment caps on an adjustable rate mortgage?

• A. Increased loan term
• B. Negative amortization
• C. Higher credit scores
• D. Full amortization

Answer: (B)

When payment caps are applied to an adjustable-rate mortgage (ARM), they limit the maximum payment amount that can be required from the borrower during each adjustment period. This can lead to a situation known as negative amortization. In negative amortization, the payments made may not cover the total interest that accrues on the loan, which means the unpaid interest is added back to the loan balance. Over time, as payments remain capped, this can cause the total amount owed to grow larger than the initial loan amount, rather than being paid down. This phenomenon is particularly dangerous for borrowers because it can lead to a significantly higher debt burden if the market or interest rates change unfavorably. Thus, payment caps can result in negative amortization, making it the correct answer in the context of potential issues that may arise from this type of mortgage structure.

When payment caps are applied to an adjustable-rate mortgage (ARM), they limit the maximum payment amount that can be required from the borrower during each adjustment period. This can lead to a situation known as negative amortization.

In negative amortization, the payments made may not cover the total interest that accrues on the loan, which means the unpaid interest is added back to the loan balance. Over time, as payments remain capped, this can cause the total amount owed to grow larger than the initial loan amount, rather than being paid down.

This phenomenon is particularly dangerous for borrowers because it can lead to a significantly higher debt burden if the market or interest rates change unfavorably. Thus, payment caps can result in negative amortization, making it the correct answer in the context of potential issues that may arise from this type of mortgage structure.