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.