What is a Negatively Amortizing Loan
A negatively amortizing loan is a loan with a payment structure that allows for a scheduled payment to be made where the payment made by the borrower is less than the interest charge on the loan. When a payment is made which is less than the interest charge at the time, deferred interest is created. The amount of deferred interest created is added to the principal balance of the loan, leading to a situation where the principal owed increases over time instead of decreases.
BREAKING DOWN Negatively Amortizing Loan
For example, consider a loan with an 8% annual interest rate, a remaining principal balance of $100,000, and a provision that allows the borrower to make $500 payments at a certain number of scheduled payment dates. The interest due on the loan at the next scheduled payment would be: 0.08 / 12 x 100,000 = $666.67. If the borrower makes a $500 payment, $166.67 in deferred interest ($666.67 - $500) will be added to the principal balance of the loan for a total remaining principal balance of $100,166.67. The next month's interest charge would be based on this new principal balance amount, and the calculation would continue each month leading to increases in the loan's principal balance, or negative amortization.
Negative amortization cannot continue indefinitely. At some point, the loan must start to amortize over its remaining term. Typically, negatively amortizing loans have scheduled dates when the payments are recalculated, so that the loan will amortize over its remaining term, or have a negative amortization limit which states that when the principal balance of the loan reaches a certain contractual limit, the payments will be recalculated.