Negative amortization is a situation in which the principal balance on a loan increases every month, rather than decreasing with each payment. This type of loan is most commonly seen in home loans, with the goal of reducing monthly payments in the early stages of the loan to make the loan easier for clients to repay. However, there are some serious risks to negative amortization loans, not the least of which is that at some point, the monthly payments will have to increase, or the loan will never be repaid.
In lender-speak, “amortization” refers to paying down the principal balance on a loan. In most instances, when someone makes a loan payment, that payment is used to pay off the interest which has accrued, and the remainder of the payment is applied to the principal. In the early stages of the loan, the payments often go almost entirely to interest, with a small fraction going to the principal, but eventually, the principal will start to go down, and the borrower is said to have “equity” in the loan.
In a negative amortization or NegAm loan, the borrower has monthly payments which do not cover the interest. As a result, at the end of the month, the unpaid interest is added to the balance of the loan, causing it to increase. These types of loans are often used to give home buyers low monthly payments in the early stages of their loan, but eventually the payments will be adjusted, sometimes in combination with a “balloon payment” which is designed to pay down a large chunk of the principal.
People often use negative amortization loans when they think that the value of an asset is going to increase significantly, and that therefore they can potentially refinance the asset at a better interest rate and a higher amount, paying off the original loan and obtaining a new loan with more favorable terms. The obvious problem with this tactic is that if the value of the asset stays the same or depreciates, refinancing may not be an option, and in cases where the depreciation is severe, the jump in monthly payments may become a serious issue.
Financial advisers have mixed advice about negative amortization loans. Borrowers should certainly not embark on such a loan without being aware of it, and they may want to consider asking for a disclosure of how much they will pay over the lifetime of the loan. Many lenders are happy to provide information about how much monthly payments would be after the influence of assorted variables, such as shortening or extending the term, or taking out an adjustable rate mortgage (ARM) in which initial payments are low.