What Is Negative Amortization? Definition and Examples
Negative amortization refers to a situation where the outstanding principal balance on a loan increases over time rather than decreasing.
This occurs when the payments made are insufficient to cover the interest costs charged on the loan. The unpaid interest gets added to the principal balance, causing it to grow.
Definition of Negative Amortization
Negative amortization can be defined as a loan repayment structure where the borrower’s payments do not fully cover the interest costs charged on the loan.
This leads to a portion of the interest being added to the principal balance, resulting in the principal owed increasing instead of decreasing with each payment.
The term “amortization” refers to the process of paying off a loan through scheduled repayments over time. In a standard amortizing loan, the payments made by the borrower cover both interest costs and principal so that the loan balance declines with each payment.
Negative amortization is the opposite situation where the principal balance rises due to the borrower’s payments being insufficient to cover accruing interest costs.
How Negative Amortization Works
Negative amortization occurs when the payments made are less than the total interest costs charged over that period. For example, consider a borrower who takes out a $100,000 loan at a 10% interest rate. The monthly interest on this loan would be $1,000 ($100,000 x 10%/12).
If the borrower makes monthly payments of only $500, this does not cover the $1,000 interest cost each month. So the remaining $500 interest gets added to the principal balance. After the first month, the balance would be $100,500, after the second month it would grow to $101,000 and so on.
This arrangement allows borrowers to make lower payments in the short-term. However, it causes the total amount owed to increase over time as unpaid interest gets added to principal.
Types of Loans with Negative Amortization
Certain types of loans, especially mortgages, are structured to allow for negative amortization. The main examples include:
- Adjustable-rate mortgages (ARMs) – Some ARMs allow borrowers to choose to only pay the interest or pay below the interest amount for a set period, leading to negative amortization.
- Interest-only loans – With interest-only loans, the borrower pays only the interest costs and none of the principal for a set term. This causes the principal balance to remain unchanged rather than decline.
- Graduated-payment mortgages – These mortgages offer low initial monthly payments that later increase at a preset schedule. The initial payments do not fully cover interest, resulting in negative amortization.
- Reverse mortgages – In these mortgages available to seniors, the borrower is not required to make repayments and all interest is capitalized, leading to negative amortization
Consider this example to understand how negative amortization works:
- John takes out a $200,000 adjustable-rate mortgage at a 5% interest rate
- His monthly interest works out to $833.33 ($200,000 x 5%/12)
- John opts to only pay $500 a month during the initial 5-year period
- This $500 payment does not cover the $833.33 monthly interest
- The remaining $333.33 interest gets added to the principal balance each month
- After one year, the principal balance has grown to $206,000
- After 5 years, the balance has grown to $249,997
This shows how choosing lower payments than required can quickly increase the amount owed on loans with negative amortization provisions.
Pros of Negative Amortization
Negative amortization loans can offer certain benefits for borrowers:
- Lower initial payments – This helps improve cash flow in the early stages of the loan.
- Ability to qualify for a larger loan – Lenders may approve larger loan amounts more easily knowing payments start low.
- Delayed payment increases – For adjustable-rate mortgages, it delays payment hikes when interest rates rise.
Cons of Negative Amortization
Despite the pros, negative amortization also comes with considerable risks:
- Increased interest costs – Unpaid interest gets added to principal, leading to higher total interest.
- Risk of payment shock – Payments can rise substantially once negative amortization periods end.
- Possibility of owing more than property value – This can occur if home prices decline while the mortgage balance rises.
How to Avoid Negative Amortization
Borrowers can avoid negative amortization risks by:
- Opting for fixed-rate mortgages or standard ARMs with fixed payments
- Selecting loans without interest-only or deferred interest features
- Making payments to cover at least interest, if not principal too
- Refinancing once principal balance rises close to limits
- Keeping loan terms short to limit potential negative amortization
- Maintaining financial discipline and not spending more just because initial payments are low
Negative amortization refers to a situation where the principal balance on a loan increases over time due to the payments made being lower than interest costs. While such loans offer more flexibility, they can be risky if borrowers are unable to handle rising payments down the road.
Being aware of how negative amortization works and avoiding loans with such features can help consumers make prudent borrowing decisions.