Definition
Negative amortization occurs when the monthly mortgage payments are not enough to cover the interest due, causing the unpaid interest to be added to the principal balance of the loan. As a result, the total amount owed increases over time instead of decreasing, putting the borrower at risk of owing more than the property’s value—a situation known as being “underwater”.
Explanation
Negative amortization is most common in adjustable-rate mortgages (ARMs) and certain types of loans with payment options, such as option ARMs or graduated payment mortgages. Borrowers may intentionally choose lower payments temporarily, anticipating increased income in the future. However, this strategy can backfire if home values decline or if income doesn’t rise as expected.
✅ Key Features of Negative Amortization:
- Minimum Payment Option: Allows paying less than the interest due, causing principal to grow.
- Interest-Only Periods: Some loans permit paying interest only for a limited time, leading to negative amortization if not managed carefully.
- Cap Limits: Some loans limit how much the principal can grow before requiring full payments.
Pros and Cons of Negative Amortization
✅ Advantages:
- Lower Initial Payments: Temporary relief for borrowers with fluctuating income.
- Flexibility: Allows borrowers to manage cash flow during lean periods.
- Access to Higher Loan Amounts: Lower payments can qualify borrowers for larger loans.
❌ Disadvantages:
- Increased Debt: Unpaid interest adds to the principal balance.
- Underwater Risk: Borrowers may owe more than the property’s worth.
- Payment Shock: Sudden and significant increases in payments when interest-only periods end.
Example
A borrower takes out an option ARM for $300,000 with a 1% minimum payment option that doesn’t cover the 4% interest due. Each month, unpaid interest is added to the principal, causing the loan balance to grow beyond the original amount. After a few years, the borrower faces a higher balance and potentially unaffordable payments when the recast period arrives, requiring full payments to cover both principal and interest.