Negative Amortization

Definition

Negative amortization occurs when the payments made on a loan are less than the interest that accrues, resulting in an increase in the loan balance over time. This situation typically arises with certain types of mortgages where the borrower opts for lower initial payments, leading to a growing debt rather than reducing it. It’s important to understand how this can impact overall loan costs and borrower equity.

5 Must Know Facts For Your Next Test

1. Negative amortization can lead to larger-than-expected loan balances when the borrower does not make sufficient payments to cover accruing interest.
2. This type of amortization is often seen in adjustable-rate mortgages (ARMs) where initial rates are low but can increase over time.
3. Borrowers facing negative amortization might experience payment shock when their monthly payments adjust to include principal repayment after a period of only paying interest.
4. It's critical for borrowers to understand the potential long-term financial implications of choosing loans that allow for negative amortization, as it can erode equity.
5. Some lenders may offer options to convert a negatively amortized loan to a standard repayment structure, but this typically comes with additional costs.

Review Questions

• How does negative amortization affect the total cost of a mortgage over its life?
  • Negative amortization significantly increases the total cost of a mortgage because the outstanding balance grows as unpaid interest accumulates. This means that over time, borrowers may find themselves owing much more than they initially borrowed, leading to higher overall payments when they eventually must start paying down the principal. Understanding this concept is crucial for assessing the long-term financial implications of certain mortgage options.
• What are some potential risks associated with choosing a loan that allows for negative amortization?
  • Choosing a loan that allows for negative amortization can lead to significant risks, including payment shock when payments adjust to cover both principal and interest. Borrowers may also find themselves underwater on their mortgage, meaning they owe more than their home is worth, which can hinder refinancing options or lead to foreclosure. These risks highlight the importance of careful financial planning and consideration of one's long-term ability to manage fluctuating payments.
• Evaluate how negative amortization could influence borrower decisions in a fluctuating interest rate environment.
  • In a fluctuating interest rate environment, negative amortization may influence borrower decisions significantly. As interest rates rise, borrowers with loans that allow negative amortization might see their monthly payments increase dramatically if they initially opted for lower payments. This could lead some borrowers to reconsider their choices, potentially seeking fixed-rate loans to avoid future payment volatility. Additionally, the increased balance due to negative amortization might make refinancing less appealing, further complicating their financial strategy during periods of rising rates.

Related terms

Amortization Schedule:

A table that details each loan payment over time, showing how much goes toward principal and interest.

Interest-Only Loan: A type of loan where the borrower only pays the interest for a specified period, usually leading to negative amortization if not followed by regular principal payments.

Loan-to-Value Ratio (LTV): A financial term used by lenders to express the ratio of a loan to the value of an asset purchased, which can be impacted by negative amortization as the loan balance increases.