What is 'Negative Amortization'
Negative amortization is an increase in the principal balance of a loan caused by a failure to make payments that cover the interest due. The remaining amount of interest owed is added to the loan's principal. For example, if the periodic interest payment on a loan is $500 and a $400 payment is allowed contractually, $100 is added to the loan's principal balance.
BREAKING DOWN 'Negative Amortization'
Negative amortization is a feature of some types of mortgages. Adjustable-rate mortgages that incorporate negative amortization are typically known as payment option ARMs. These mortgages give borrowers options that include paying all of the principal and interest, paying only the interest and paying only some of the interest.
Graduated payment mortgages also incorporate negative amortization. GPMs are fixed-rate mortgages that start with a payment level that fails to cover the full interest portion of the loan. So for the first few years, the interest that is not covered is added to the principal. Later payments cover all the interest as well as the larger principal amount.
While these mortgages can offer borrowers a low monthly payment for a short time, the payments must increase substantially at some point. Payment option ARMs have scheduled payment increases, but the amount of the increase is unknown and depends on market interest rates. As a result, payment option ARMs carry a great deal of payment shock risk. On a GPM, the date or dates when payments increase and how much they will increase are known ahead of time.