What is a Negative Amortization?

To understand negative amortization, you first must have a good understanding of basic amortization. When an individual takes out a loan to purchase a high dollar item, like a home, payments on the item will generally be paid back using an amortization method. Most amortization methods allow the homeowner to pay back their mortgage loan through a system of equal monthly installments. For example, the homeowner would make a payment of $579 every month, over a period of 30 years, to pay back a $100,000 fully amortized mortgage loan. For every month that a mortgage payment is made, part of the amortized payment goes toward paying back the principal balance of the loan and part of the mortgage payment is paid toward interest. With each payment, the principal amount owed shrinks, and at the end of the amortized loan, the balance due on the loan will generally be zero.

When negative amortization occurs, the payments made are not large enough to cover the loan’s interest, and the unpaid interest gets added to the loan’s balance. Consequently, with each payment, instead of owing less, the poor borrower ends up owing more. It’s easy to see why this situation is not to the borrower’s favor.

Negative amortization is commonly associated with certain types of adjustable rate mortgages (ARMs). In an ARM, the loan’s interest varies with certain market conditions. Most ARMs include payment plans that increase or decrease the monthly payments to match the variations in the interest rate, however some ARMs cap the payment due each month, but do not cap the interest owed. Rising interest rates can therefore easily lead to monthly payments that are lower than the interest owed, leading to negative amortization. Other types of ARMs that can lead to negative amortization have fixed monthly payment plans while still allowing the interest to fluctuate.

Some lenders may try to obfuscate the fact that a loan they want you to sign on to has negative amortization. So be careful, and make sure to ask the proper questions. Be especially vigilant if you’ve been turned down for a loan or have an unfavorable credit rating.