How Payment Caps Can Secure Your Mortgage
A payment cap is a contractual limit on the percentage amount of adjustment allowed in the monthly payment for an adjustable-rate mortgage during any given adjustment period. Typically, it does not directly affect the interest rate being charged. When the allowable payment does not cover the interest due on the principal at the adjusted rate, negative amortization occurs.
Example Scenario
Consider an adjustable-rate mortgage with an annual payment cap of 7%. If the monthly payment in the first year is $500, and the interest rate is adjusted in the second year, the new payment required to cover both interest and principal amortization might be $550. However, due to the 7% payment cap, the maximum payment in the second year can only be $535 ($500 plus 7% of $500).
Here’s how it breaks down:
- Initial Monthly Payment (Year 1): $500
- Required Payment After Interest Adjustment: $550
- Payment Cap Limit (Year 2): $500 + (7% of $500) = $535
The $15 difference between the required payment and the payment cap amount leads to negative amortization, meaning the unpaid interest gets added to the loan principal, increasing the total debt owed.
Benefits of Payment Caps
- Predictable Payments: Borrowers benefit from more predictable monthly payment amounts despite interest rate fluctuations.
- Financial Cushion: Provides a financial cushion by limiting the monthly increase, preventing sudden spikes in payments.
Potential Drawbacks
- Negative Amortization Risk: As highlighted, when payments do not cover interest, the unpaid portion is added to the principal, increasing overall debt.
- Prolonged Loan Period: Consistent use of payment caps can lead to an extended repayment period due to accumulating unpaid interest.
Frequently Asked Questions
What is a payment cap?
A payment cap limits the amount by which your monthly adjustable-rate mortgage (ARM) payment can increase during any specific adjustment period, protecting you from significant payment increases.
How is a payment cap different from an interest rate cap?
While a payment cap limits your monthly payment adjustment, an interest rate cap directly limits how much your loan’s interest rate can rise, affecting overall interest calculations.
Can a payment cap cause negative amortization?
Yes, if your capped payment does not fully cover the interest due, the unpaid interest portion is added to your principal balance, leading to negative amortization.
Are payment caps beneficial?
Payment caps can provide stability and financial predictability for borrowers, but they can also result in higher debt over time because of negative amortization.
How can I avoid negative amortization with a payment cap?
One way to avoid negative amortization is to make additional principal payments whenever possible to counteract the buildup of interest. Careful financial planning is also essential.
Related Terms: interest rate, amortization, adjustable-rate mortgage, mortgage cap.
