What Is a Negatively Amortizing Loan?

A negatively amortizing loan, sometimes called a negative amortization loan or negative amortized loan, is one with a payment structure that allows for a scheduled payment to be made by the borrower that is less than the interest charge on the loan. When that happens, 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.

Negative amortizing on a loan cannot go on indefinitely; at some point payments must be recalculated so that the loan’s balance and interest begin being paid down.

How a Negatively Amortizing Loan Works

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.

This is called “negative amortization,” and it 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 they will 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.

Special Considerations for Negatively Amortizing Loans

Negatively amortizing loans are considered predatory by the federal government and were banned in 25 states as of 2008, according to the National Conference of State Legislatures. Their appeal is obvious: an up-front low monthly payment. However, they inevitably end up costing the consumer more—often a good deal more, as you end up paying interest on interest as well as principal. You should understand the terms of a negatively amortizing loan very clearly—and be realistic about your ability to pay it off—before deciding to take one out.