Defined negative amortization

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What is negative amortization?

Negative amortization is a financial term referring to an increase in the principal balance of a loan caused by non-payment of interest owed on that loan. For example, if the interest payment on a loan is $ 500 and the borrower pays only $ 400, then the difference of $ 100 would be added to the principal balance of the loan.

Key points to remember

  • A negative amortization loan is a loan in which the unpaid interest is added to the outstanding principal balance.
  • Negative amortizations are common among certain types of mortgage products.
  • While negative amortization can help provide more flexibility to borrowers, it can also increase their exposure to interest rate risk.

Understanding negative amortization

In a typical loan, the principal balance is gradually reduced as the borrower makes their payments. A negative amortization loan is essentially the reverse phenomenon, where the principal balance increases when the borrower does not make their payments.

Negative amortization is present in some types of mortgages, such as variable rate mortgages (ARMs) with payment option, which allow borrowers to determine the interest portion of each monthly payment they choose to pay. Any portion of the interest they choose not to pay is then added to the principal balance of the mortgage.

Another type of mortgage that incorporates negative amortizations is what is known as the Progress Payment Mortgage (PMM). With this model, the amortization schedule is structured so that the first installments only include a portion of the interest that will be charged thereafter. While these partial payments are being made, the portion of the missing interest will be added to the principal balance of the loan. In subsequent payment periods, the monthly payments will include full interest, which will cause the principal balance to decline more quickly.

While negative amortizations provide flexibility to borrowers, they can ultimately prove costly. For example, in the case of an ARM, a borrower may choose to delay paying interest for many years. While this can help ease the burden of short-term monthly payments, it can expose borrowers to serious future payment shock in the event that interest rates rise later. In this sense, the total amount of interest paid by borrowers could ultimately be much greater than if they had not initially counted on negative amortizations.

Concrete example of negative amortization

Consider the following hypothetical example: Mike, a first-time home buyer, wants to keep his monthly mortgage payments as low as possible. To achieve this, he opts for an ARM, choosing to pay only a small portion of the interest on his monthly payments.

Suppose Mike got his mortgage when interest rates were historically low. Despite this, his monthly mortgage payments eat up a significant percentage of his monthly income, even when he takes advantage of the negative amortization offered by the ARM.

While Mike’s payment plan may help him manage his spending in the short term, it also exposes him to greater long-term interest rate risk because if future interest rates rise, he may not be able to pay their adjusted monthly payments. Also, since Mike’s low interest rate strategy drives his loan balance down more slowly than he would otherwise, he will have more principal and interest to pay back in the future than he does. ‘he had simply paid all of the interest and principal he owed everyone. month.

Negative amortization is also called “NegAm” or “deferred interest”.


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