DEFINITION of Negative Amortization Limit
The negative amortization limit is a provision in certain bonds or other loan contracts that limits the amount of negative amortization that can take place. A loan negatively amortizes when scheduled payments are made that are less than the interest charge due on the loan at the time. When a payment is made that is less than the interest charge due, deferred interest is created and added to the loan's principal balance, creating negative amortization. A negative amortization limit states that the principal balance of a loan cannot exceed a certain pre-specified amount, usually designated as a percentage of the original loan balance. Such limits prevent borrowers from getting into situations where they become unable to pay back the loan and are forced to default or declare bankruptcy - and so also protects lenders from default risk.
BREAKING DOWN Negative Amortization Limit
Negative amortization occurs when the monthly payments on a loan are insufficient to pay the interest accruing on the principal. The additional interest expense is added to the loan balance. The increased loan balance results in higher interest expense and an increasing loan balance. Thus, the term “negative amortization” since the payments are insufficient to amortize the loan balance. In the case of a negatively amortized mortgage, the homeowner is, in effect, borrowing more money each month to cover the interest on the loan, for instance the monthly payment on an interest-only payment. Until the loan starts to amortize, there isn’t a principal part of the monthly payment. This situation can help with current cash flows, but it does not actually help to pay off the mortgage balance.
Often, these types of loans will have a limit on the amount of negative amortization that can accrue on the loan - set typically as a percentage of the loan's original size. A negative amortization limit prevents a loan's principal balance from becoming too large, causing excessively large payment increases to pay back the loan by the end of its term. For instance, a negative amortization limit of 15% on a $500,000 loan would specify that the amount of negative amortization would not exceed $75,000.
When a negative amortization limit is reached on a loan, a recasting of the loan's payments is triggered so that a new amortization schedule is established and the loan will be paid off by the end of its term. This may be as simple as negotiating a refinancing of the original loan.