What is negative amortization?
Negative amortization describes the process that causes a loan balance to increase over time, despite regular payments being made. This occurs when your monthly payments do not cover all the interest you’ve been charged that month. The unpaid interest is added to the principal, and the following month you’ll be charged interest on the new, higher balance (the principal plus the previous month's unpaid interest). Negative amortization may also be referred to as “NegAm” or “deferred interest” or “compound interest.”
Example of negative amortization
Let's say you took out a $200,000 30-year fixed mortgage with a 6% annual interest rate. The fully amortizing monthly payment for this loan would be approximately $1,199.10. In month 1 of your mortgage payments, $1,000 would go to interest and $199.10 would go to paying down your principal (a.k.a your mortgage balance).
If you paid less than the interest due on your mortgage payment, then that is negative amortization. For example:
- Interest owed: $1,000
- Payment made: $900
- Shortfall: $100
The $100 shortfall would be added to the principal loan balance, which would be $200,100 at the end of the first month. This process is known as negative amortization, where the loan balance increases because the payments do not cover the interest.
If this pattern continues, the loan balance will keep growing despite regular payments. Over time, you could owe more than the original $200,000 borrowed. This can result in being "underwater" on your mortgage, where the amount owed exceeds the home's value.
Purposes and Consequences of Negative Amortization
Historically, negative amortization has been used to reduce mortgage payments at the beginning of the loan contract. It allows borrowers to make smaller payments initially, expecting increased payments later. This can occur with both fixed-rate and adjustable-rate mortgages.
Fixed-Rate Loans: Negative amortization can reduce payments in the early years at the cost of raising payments later, often seen in graduated payment mortgages (GPMs).
Adjustable-Rate Mortgages (ARMs): Negative amortization can reduce the potential for payment shock by allowing smaller payments initially, even if interest rates rise later.
The downside is that the larger the amount of negative amortization and the longer it continues, the greater the payments required later to amortize the loan fully. By understanding negative amortization, you can better assess the long-term implications of your mortgage payment strategy and avoid potential financial pitfalls.
Related term: Amortization