What is one consequence of a Payment Cap on an ARM loan?

A Payment Cap on an Adjustable Rate Mortgage (ARM) limits the amount that the borrower's monthly payment can increase at each adjustment period. While this provides some predictability to monthly payments, it can also lead to negative amortization. This occurs when the payment made by the borrower is not sufficient to cover the interest that accrues on the loan for that period.

As a result, the unpaid interest is added to the principal balance of the loan, increasing the total amount owed over time. Therefore, even though the borrower's payment is capped, the loan balance can grow due to this deferred interest. This can create significant financial challenges for the borrower in the long run, as they may owe more than the original amount borrowed, particularly if payment caps persist through multiple adjustment periods.

Understanding how Payment Caps function within the framework of an ARM is crucial for loan officers, as it impacts the long-term financial implications for borrowers.