What Is Negative Amortization?
Let me explain negative amortization to you directly: it's a financial term that describes when the principal balance of a loan actually increases because you haven't covered the full interest due on that loan. For instance, if your interest payment is $500 and you only pay $400, that $100 shortfall gets added right to the loan's principal balance.
Key Takeaways
- A negative amortization loan adds unpaid interest to the unpaid principal balance.
- You'll find negative amortizations in specific mortgage products.
- While it gives borrowers more flexibility, negative amortization heightens their exposure to interest rate risk.
Understanding Negative Amortization
In a standard loan, you reduce the principal balance over time as you make payments. With negative amortization, it's the opposite: the principal grows if you fail to make full payments.
You see negative amortizations in certain mortgage loans, like payment option adjustable-rate mortgages (ARMs), where you decide how much of the interest to pay each month. Any interest you skip gets added to the principal balance of the mortgage.
Another example is the graduated payment mortgage (GPM). Here, the amortization schedule starts with payments that cover only part of the interest, and the missing interest gets added to the principal. Later on, payments include the full interest, which then reduces the principal more quickly.
Sure, negative amortizations offer flexibility, but they can end up costing you more. Take an ARM: you might delay interest payments for years to ease short-term burdens, but if rates spike, you could face severe payment shock. Ultimately, you might pay far more in total interest than if you'd avoided negative amortization altogether.
Real-World Example of Negative Amortization
Consider this hypothetical scenario: Mike, a first-time home buyer, wants to minimize his monthly mortgage payments. He chooses an ARM and opts to pay only a small part of the interest each month.
Assume Mike got his mortgage during a period of low interest rates. Even so, his payments eat up a big chunk of his income, especially when he uses the negative amortization feature of the ARM.
This approach helps Mike handle his short-term expenses, but it leaves him vulnerable to long-term interest rate risks. If rates go up, he might not afford the adjusted payments. Plus, since his strategy slows the decline of the loan balance, he'll have more principal and interest to pay back later than if he'd covered the full amounts monthly.
Important Note
You might hear negative amortization called 'NegAm' or 'deferred interest' in other contexts.
