Payment cap
A limit on how much monthly payments can fluctuate on an Adjustable Rate Mortgage (ARM).
Some ARMs have a payment cap, where payments are typically limited to a 7.5% change, up or down, every 12 months. The payment cap feature is usually offered with a low initial rate. The combined benefit is very low minimum payments in the first year, followed by moderate payment increases (7.5%) in subsequent years.
One potential disadvantage of a payment cap is that interest accrues at the higher, fully indexed rate after the low initial rate expires. Any difference between the payment you make and the interest accrued is added to the loan balance. As a result, the mortgage balance can increase over time. This is called negative amortization.
Example: How can a payment cap cause negative amortization on a $100,000 loan at 6% interest with a 7.5% payment cap?
At a 6% interest rate, you pay $600 a month. If the interest rate changed to 8%, you would pay $734 per month. However, since you have a payment cap of 7.5%, the maximum that you have to pay is $645 ($600 + [$600 x 7.5%]). What happens to the ($734 - $645) = $89 difference? If the lender allows negative amortization and you pay the minimum amount, the $89 in interest is deferred and added to your loan balance.