Definition
Negative Amortization is a finance term referring to an increase in the principal balance of a loan caused by making payments that fail to cover the interest due. The remaining amount of interest owed is added to the loan’s principal, causing the borrower to owe more than the original loan amount. It typically occurs in adjustable-rate mortgage loans.
Key Takeaways
- Negative Amortization is a complex system of finance where the loan payments for a period don’t cover the interest expense accrued for that same period. This scenario causes the outstanding balance of the loan to increase rather than decrease over time.
- This particular financial structure can occur in some types of adjustable-rate mortgages and student loans. While it may initially offer a lower monthly payment, negative amortization can ultimately lead to higher loan balances that will need to be paid off later, posing a potential financial risk for the borrower.
- Given the risks associated, negative amortization should be approached with caution. It’s crucial to understand the lending terms completely before entering into such an arrangement and consider alternative financing methods that contribute to equity building and can create more stable financial footing.
Importance
Negative Amortization is an important finance term because it relates to a situation where the principal balance on a loan increases rather than decreases over time.
This typically occurs when the borrower’s payments do not fully cover the interest accrued on the loan, resulting in the unpaid interest being added back to the loan balance.
As a result, the borrower ends up owing more than the original loan amount.
Understanding negative amortization is essential for anybody dealing with loans, as it can have a significant impact on a person’s long-term financial plans and commitments.
Proper knowledge of this term can assist in making more informed decisions about loan repayment strategies and avoidance of potential financial pitfalls.
Explanation
Negative Amortization is a unique financial feature typically utilized in special types of loans such as Adjustable Rate Mortgages (ARMs), Graduated Payment Mortgages (GPMs), or Home Equity Lines of Credit (HELOCs). The purpose of this feature lies in the flexibility it provides to borrowers, allowing them to make low payments in the initial years of a loan, especially beneficial for those who expect an increase in their earnings over time.
By making smaller payments, this can alleviate immediate financial burdens, however, resulting in unpaid interest that is added onto the principal balance of the loan.
The added amount due to negative amortization often results in an increase in the loan’s total balance, which is significantly called ‘negative amortization.’ On the flip side, this can lead to a circumstance known as ‘underwater mortgage’ where one owes more on their home than its market value if the property’s value decreases.
Despite its inherent risks, negative amortization is used as a financial strategy to provide temporary relief from high monthly loan payments, giving borrowers the opportunity to move towards greater financial stability over time.
Examples of Negative Amortization
Adjustable-Rate Mortgages (ARMs): These types of loans begin with a low, fixed rate, and then adjust according to market rates. If the market rate increases significantly, the monthly payment may not cover the entire interest due each month. The unpaid interest is then added to the loan balance, resulting in negative amortization.
Graduated Payment Mortgages (GPM): These are often offered to first-time homeowners with the expectation of income increases over time. The initial payments are intentionally set low and then increase over time. However, the early low payments do not meet the interest cost, resulting in negative amortization.
Payment Cap on Adjustable Rate Loan: Some adjustable rate mortgages come with a payment cap. If the adjustable interest rate rises above your monthly payment cap, you could be making a monthly payment that is less than the required interest, hence the difference in the unpaid interest is added back into your loan principal, resulting in negative amortization.
Negative Amortization FAQs
What is Negative Amortization?
Negative amortization is a situation that occurs when the monthly payments on a loan are not enough to cover the interest expense. This results in an increase in the principal balance of the loan, rather than a decrease as is typical in regular amortization schedules.
How Does Negative Amortization Happen?
Negative amortization happens when a loan’s terms allow for a borrower to make payments smaller than the interest charges each month. The unpaid interest is then added to the loan’s principal, causing the balance of the loan to increase.
What is a Negative Amortization Loan?
A negative amortization loan, often referred to as a NegAm loan, is a type of mortgage loan in which the homeowner can make lower payments by deferring some of the interest due to a later period. This causes the loan balance to increase over time instead of decrease.
What are the Pros and Cons of Negative Amortization Loans?
The main benefit of negative amortization loans is that they initially allow for lower monthly payments. However, these loans often result in larger payment obligations later in the loan term due to the increased principal balance. These types of loans are risky and can lead to borrowers owing more than their original loan amount if not managed properly.
How to Avoid Negative Amortization?
To avoid negative amortization, ensure your monthly loan payments are sufficient to cover at least the interest due. This can be done by understanding your loan terms thoroughly and potentially seeking advice from financial professionals.
Related Entrepreneurship Terms
- Adjustable-Rate Mortgage
- Graduated Payment Mortgage
- Interest Capitalization
- Mortgage Principal
- Payment Cap
Sources for More Information
- Investopedia: A trusted source for investment definitions and concepts, including negative amortization.
- Bankrate: Offers consumer financial advice and definitions, including information about different types of loan amortization.
- The Balance: Provides comprehensive articles, guides, and advice on personal finance, including detailed insights into loan amortization and its negative aspects.
- NerdWallet: Offers financial tools, advice, and reviews, including information on negative amortization.
