Negatively Amortizing Loan: Overview, History, FAQ

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 charged 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.

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.

History of Negatively Amortizing Loans

Negatively amortizing loans can be considered predatory, as not all borrowers understand why they may be allowed to make lower payments than required. Of course, this ends up benefiting the lender, and those not financially savvy enough to understand this can end up in deep water.

The world saw what would happen when a large percentage of negatively amortized loans exist in the market when the global financial crisis of 2008 started developing. Many homebuyers were overleveraged on their mortgage(s) and because of this, they were given the option to make payments lower than what would cover the interest.

Banks were already writing many subprime mortgages they knew were risky. Allowing for negatively amortizing loans to occur in combination with adjustable-rate mortgages was one of the most significant factors of the global financial crisis. Simply put, interest rates rose, people with mortgages were unable to make their full payments and, despite making payments, found themselves further in debt.

Negatively Amortizing Loan vs. Self-Amortizing Loan

Negatively amortizing loans will grow over time, extending the payment timeline. Self-amortizing loans are the opposite and will fully amortize when made on schedule.

Most traditional mortgages are self-amortizing. These types of loans are consistent and predictable, making them attractive to both the lender and the borrower. The world saw in 2008 what happens when banks become greedy and place people in positions where they are unable to make ever-increasing payments or payments that extend beyond the predictability of a self-amortizing loan cycle.

Special Considerations

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.

The Bottom Line

It's good practice to make sure you are making timely payments on your loans. What is equally important is to make those payments enough to not only cover the interest but to make payments on the principal as well. This will help avoid falling into the negative amortization trap. If that happens you are extending the life of your loan and will end up paying much more in interest than you had planned.