Question: I have read your past articles on the LIBOR ARM and have decided that my wife and I are good candidates for such a program. We have found a local lender who is offering a monthly LIBOR ARM with a 2.00 percent margin. We think it's a great mortgage program because the fully indexed rate is only 3.25 percent. The only thing that scares us is that the loan has the potential of negative amortization if rates jump. You had suggested that borrowers beware of loans with negative amortization. Should we abandon this program?

Answer: Not necessarily. Indeed, I have often warned borrowers about negative amortization because it can be a bad thing. I'm glad you asked me this question because it provides a good opportunity to explain negative amortization.

Back in 1997, when fixed rates were beginning to fall, a retired couple contacted me about refinancing their home. They had been paying the minimum required payment on a monthly ARM for more than two years. During the course of our telephone conversation, I learned that these folks, although enjoying a very low mortgage payment, had unknowingly increased their mortgage balance by $20,000, thanks to negative amortization.

For those readers unfamiliar with "neg-am" let me explain. A loan that allows negative amortization means the borrower is allowed to make a monthly mortgage payment that is less than the interest actually owed during that month. For example, let's say we have a $200,000 loan with an adjustable rate that's currently sitting at five percent. Simple interest on this loan is easy to calculate. Multiply the interest rate by the loan amount and you have the annual interest of $10,000. Divide $10,000 by 12 months and the monthly "interest only" payment is $833.33.

Now, let's say that there's a provision in the loan documents that allow the borrower to make a minimum payment based on a "payment rate" of four percent. So your lowest payment would be $666.67 because the "payment rate" is based upon four percent, not the actual interest rate, which is five percent.

So the folks that make the lowest allowable payment are actually losing $166.67 in equity. The balance of the loan increases to $200,166.67.

Is this a bad thing? Not necessarily. It could be a good thing if the borrower understands that in exchange for the ultra-low monthly payment, his loan balance goes up. So when I advise readers to beware of loans with negative amortization, I'm advising that any reader considering such a product understand it completely. A lot of folks confuse the actual interest rate with the "payment rate." Make sure you understand your true interest rate.

In addition, loans that allow negative amortization will also allow an interest-only payment option, or a payment that will curtail principle. You won't be forced into making the neg-am payment.

The bottom line -- a rock bottom payment that carries negative amortization isn't a free lunch. You pay the piper eventually and as long as the borrower understands what's going on, he can make an informed decision.

Published: November 13, 2003

Use of this article without permission is a violation of federal copyright laws.

, the president of PMC Mortgage Corporation in Alexandria, VA, is a mortgage columnist whose work has appeared in numerous consumer, real estate, and mortgage publications. Mr. Savage welcomes your questions for possible use in this column, however because of the volume of mail received, Mr. Savage cannot answer questions individually.