What Is Negative Amortization?
For example, if the interest payment on a loan is $500, and the borrower only pays $400, then the $100 difference would be added to the loan's principal balance.
- A negative amortization loan is one in which unpaid interest is added to the balance of unpaid principal.
- It is common among certain types of mortgage products.
- Although negative amortization can help provide more flexibility to borrowers, it can also increase their exposure to interest rate risks.
Understanding Negative Amortization
In a typical loan, the principal balance is gradually reduced as the borrower makes payments. A negative amortization loan is essentially the opposite concept, in that the principal balance grows when the borrower fails to make payments.
Negative amortizations are a feature of some types of mortgage loans. For instance, payment option adjustable-rate mortgages (ARMs) allow borrowers to decide how much of the interest portion of each monthly payment they wish to pay. Any portion of interest that they choose not to pay is then added to the principal balance of the mortgage, as per our example above.
Another example of mortgages which incorporate negative amortizations are so-called graduated payment mortgages (GPMs). For these types of mortgages, the amortization schedule is structured so that the first payments include only a portion of the interest that will later be charged. While these partial payments are being made, the missing interest portion will be added back to the principal balance of the loan. In later payment periods, the monthly payments will include the full interest component, causing the principal balance to decline more rapidly.
Although negative amortizations can be attractive to some borrowers because of the flexibility they provide, they can ultimately prove quite costly. For example, in the case of an ARM, a borrower may choose to delay paying interest for many years. Although this can help ease the burden of monthly payments in the short term, it can expose the borrowers to severe payment shock in the future, in the event that interest rates rise later on. In this sense, the total amount of interest paid by the borrower may ultimately be far greater than if they had not taken advantage of the negative amortization options.
Real-World Example of Negative Amortization
Mike is a first-time homebuyer who wishes to keep the monthly payments on his mortgage as low as possible. To achieve this, he opts for an ARM and elects to pay only a small portion of the interest on his monthly payments.
Mike obtained his mortgage at a time when interest rates were historically low. Yet despite this, his monthly mortgage payments take up a significant percentage of his monthly income—even when he takes advantage of the negative amortization offered by the ARM.
Although Mike's payment plan may help him manage his expenses in the short-term, it is also exposing him to greater long-term interest rate risks. This is because, if interest rates rise in the future, he may be unable to afford his adjusted monthly payments. Moreover, because Mike's low-interest-payment strategy is causing his loan balance to decline more slowly than it would otherwise, he will have more principal and interest to repay in the future than if he had simply paid the full interest and principal owing each month.