Negative amortization is a financial term referring to an increase in the principal balance of a loan caused by a failure to cover the interest due on that loan. For example, if the interest payment on a loan is $500, and the borrower only pays $400, then the $100 difference would be added to the loan’s principal balance.
Key Takeaways
- A negative amortization loan is one in which unpaid interest is added to the balance of unpaid principal.
- Negative amortizations are common among certain types of mortgage products.
- Although negative amortization can help provide more flexibility to borrowers, it can also increase their exposure to interest rate risk.
Dive Deep into Negative Amortization
In a typical loan, the principal balance is gradually reduced as the borrower makes payments. However, a negative amortization loan is essentially the reverse phenomenon, where the principal balance grows when the borrower fails to make full payments.
Negative amortizations are featured in some types of mortgage loans, such as payment option adjustable-rate mortgages (ARMs), which let borrowers determine how much of the interest portion of each monthly payment they elect to pay. Any portion of interest that they opt not to pay is then added to the principal balance of the mortgage.
Another type of mortgage that incorporates negative amortizations is the graduated payment mortgage (GPM). With this model, the amortization schedule is structured so that the first payments include only a portion of the interest that will later be charged. While these partial payments are being made, the missing interest portion will be added back to the principal balance of the loan. In later payment periods, the monthly payments will include the full interest component, causing the principal balance to decline more rapidly.
Although negative amortizations afford flexibility to borrowers, they can ultimately prove costly. For example, in the case of an ARM, a borrower may choose to delay paying interest for many years. Although this can help ease the burden of monthly payments in the short term, it can expose borrowers to severe future payment shock in the event that interest rates spike later on. In this sense, the total amount of interest paid by borrowers may ultimately be far greater than if they hadn’t relied on negative amortizations to begin with.
Real-World Example of Negative Amortization
Consider the following hypothetical example: Mike, a first-time homebuyer, wishes to keep his monthly mortgage payments as low as possible. To achieve this, he opts for an ARM, electing to pay only a small portion of the interest on his monthly payments.
Let us assume that Mike obtained his mortgage when interest rates were historically low. Despite this, his monthly mortgage payments gobble up a significant percentage of his monthly income—even when he takes advantage of the negative amortization offered by the ARM.
Although Mike’s payment plan may help him manage his expenses in the short term, it also exposes him to greater long-term interest rate risk because if future interest rates rise, he may be unable to afford his adjusted monthly payments. Furthermore, because Mike’s low-interest-payment strategy is causing his loan balance to decline more slowly than it would otherwise, he will have more principal and interest to repay in the future than if he had simply paid the full interest and principal he owed each month.
Negative amortization is alternatively referred to as “NegAm” or “deferred interest.”
Related Terms: principal, interest, mortgage, ARM, GPM, amortization schedule, payment shock, loan balance
