What Is an Interest Shortfall?

An interest shortfall is the accrued interest due that remains after a borrower has made their monthly payment. This can lead to negative amortization on some adjustable rate loans. Negative amortization is a financial term referring to an increase in the principal balance of a loan caused by a failure to cover the interest due on that loan.

Key Takeaways

  • An interest shortfall occurs when the accrued interest owed on a debt payment is not fully covered.
  • This may occur on a variable rate loan where an interest rate cap limits monthly payments to a level less than the total interest due otherwise.
  • Interest shortfalls on ARM mortgages can result in negative amortization, leading to a longer repayment period for the loan.

How Interest Shortfalls Work

Interest shortfalls are a feature of adjustable-rate mortgages (ARMs), in which the interest rate applied to the outstanding balance varies throughout the life of the loan. When rate caps limit monthly loan payments, the homeowner’s payments may be less than the actual interest due. This unpaid interest increases the outstanding principal balance of the loan, which is called negative amortization.

While negative amortization protects borrowers from payment shock associated with a sudden increase in the ARM interest rate, it will take longer to fully amortize the loan. If interest rates continue rising, the equity in the home will decline rather than rise, unless the price of the house rises. Most mortgages have limits on interest shortfall, to protect both borrower and lender. A lifetime cap is the maximum upper limit interest rate allowable on an ARM. The cap applies to the life of the mortgage. This cap informs a borrower of the maximum interest rate they could pay during the life of the loan. 

Payment shock is the risk that a loan's scheduled future periodic payments may increase substantially and may cause the borrower to default on the loan, and is associated with ARMs.

Interest Shortfalls in MBS

In the mortgage backed security (MBS) market, interest shortfalls occur when the interest distributed is less than the amount of interest accrued as a result of mortgage prepayments. Interest shortfalls occur when fees and expenses associated with troubled loans reduce the amount of interest available to be paid on a mortgage backed security. If there’s an interest shortfall, interest is deferred, with subordinate classes usually the first to be affected with more senior tranches get repaid first.