Negative Amortization

Negative Amortization

Key takeaways
* Negative amortization occurs when unpaid interest is added to a loan’s principal, causing the balance to rise.
* It commonly appears in certain mortgage products, such as payment-option ARMs and graduated payment mortgages.
* While it can lower short-term payments, it increases exposure to interest-rate risk and can raise the total amount repaid.

What negative amortization means
Negative amortization (often called “NegAm” or “deferred interest”) happens when a borrower’s payment does not cover the interest due. The unpaid interest is capitalized—added to the outstanding principal—so the loan balance grows instead of shrinking.

How it works
* Normal amortization: payments cover interest and reduce principal over time.
* Negative amortization: payments are smaller than the interest due, so unpaid interest is added to principal, increasing the balance.
* Over time, monthly payments may be recalculated to cover the larger principal and accrued interest, potentially causing payment increases.

Loan types that use negative amortization
* Payment-option adjustable-rate mortgages (ARMs): borrowers can choose lower payments that may not cover full interest; unpaid interest is added to the loan balance.
* Graduated payment mortgages (GPMs): initial payments are deliberately low and may cover only part of the interest; the unpaid portion is added to principal, with payments increasing in later periods to amortize the loan.

Risks and consequences
* Payment shock: if rates rise or the negative amortization period ends, required payments can jump sharply.
* Higher overall cost: accruing interest increases the principal, which in turn generates more interest, often resulting in greater total interest paid.
* Potential for negative equity: the loan balance can grow faster than the property value, increasing the risk of being “underwater.”

Example
A borrower chooses a payment-option ARM and makes monthly payments that only cover part of the interest. Each month, the unpaid interest is added to the principal. Although monthly cash flow is easier initially, the outstanding balance increases and future payments can rise significantly if rates increase or the loan recasts to full amortization.

Bottom line
Negative amortization can provide short-term payment relief but shifts costs to the future and raises financial risk. Borrowers should understand how unpaid interest is handled, how and when payments can change, and the long-term implications before choosing a loan that allows negative amortization.