What type of loan is often characterized by lower initial payments with potential for negative amortization due to payment caps?

An Adjustable Rate Mortgage (ARM) is characterized by lower initial payments that can result in negative amortization if the payment amount is capped. In an ARM, the interest rate is typically lower during an initial fixed-rate period, which leads to smaller monthly payments. However, once the initial period ends, the interest rate adjusts periodically based on market indices, which may lead to higher payments that exceed the initial capped amount.

When the payments do not cover the interest accrued in a given period, the unpaid interest is added back to the principal balance, causing the loan amount to grow instead of shrink—this is known as negative amortization. The potential for this outcome is a notable risk associated with ARMs, particularly when payment caps are set, limiting how much the monthly payment can increase regardless of how much interest is due.

Understanding the structure of ARMs is crucial for both mortgage professionals and borrowers, as it highlights the importance of evaluating long-term financial implications and the volatility of interest rates over time.