How Can a Loan Balance Increase with Payments?
Ordinarily, when you make payments on a loan, you expect the balance to decrease. However, with negative amortization, the opposite can happen. This situation arises when your monthly loan payment is not large enough to cover all the interest that has accrued that month. The unpaid interest is then added to your loan’s principal balance, causing your total debt to grow.
Think of it like trying to bail water out of a boat with a small bucket while a larger hose is filling it up. Even though you are actively bailing, the water level continues to rise. The unpaid interest capitalizes, meaning you begin paying interest on the interest, creating a dangerous financial cycle.
This feature was most common in “Option ARM” or “pick-a-payment” mortgages, which gained popularity before the 2008 financial crisis. These loans offered a very low minimum payment option that was often insufficient to cover the interest due.
An Example of Negative Amortization in Action
Let’s say you have a $400,000 mortgage with a 6% annual interest rate.
- Monthly Interest Accrued: ($400,000 × 0.06) / 12 = $2,000
- A standard payment to pay off the loan in 30 years would be approximately $2,398.
However, your loan allows for a minimum payment of only $1,500. Here is how your loan balance would change after making that payment:
| Description | Amount | Impact |
|---|---|---|
| Interest Owed for the Month | $2,000 | This is the cost of borrowing for the month. |
| Your Minimum Payment | -$1,500 | You paid this amount. |
| Unpaid (Deferred) Interest | $500 | The interest your payment did not cover. |
| Original Loan Balance | $400,000 | Your starting debt. |
| New Loan Balance | $400,500 | Your debt grew by the unpaid interest amount. |
Despite making a $1,500 payment, you now owe $500 more than you did at the start of the month. The following month, interest will be calculated on this new, higher balance.
The Dangers: Payment Shock and Lost Equity
Negative amortization loans pose two significant risks:
- Payment Shock: These loans do not allow the balance to grow indefinitely. After a specific period (e.g., five years) or if the balance reaches a certain cap (e.g., 110% of the original loan), the loan “recasts.” This forces a recalculation of your payment to a new, much higher amount that will pay off the larger principal over the remaining term. This abrupt increase, known as “payment shock,” led to many foreclosures during the housing crisis.
- Lost Home Equity: As your loan balance increases, your home equity—the portion of your home you own—decreases. If the property’s value stays flat or falls, you could end up “underwater,” owing more than the home is worth.
Are Negative Amortization Mortgages Still Available?
For residential mortgages, negative amortization loans are now very rare. Following the 2008 crisis, the Dodd-Frank Act established the “Ability-to-Repay” (ATR) rule. According to the Consumer Financial Protection Bureau (CFPB), this rule requires lenders to make a good-faith determination that a borrower can afford their loan payments.
Due to the risk of payment shock, most loans with negative amortization do not meet the criteria for a “Qualified Mortgage” (QM), a category of loans that offers lenders greater legal protection. Consequently, lenders have largely stopped offering them for primary residences. You might still find this feature in some specialized business or investment property loans.
Frequently Asked Questions (FAQ)
Is negative amortization the same as an interest-only loan?
No. With an interest-only loan, your payments cover all the interest each month, so your balance remains flat for a set period. With negative amortization, your payments are less than the interest, so your loan balance actively grows.
How can I tell if my loan has negative amortization?
Review your loan’s closing disclosure or promissory note for terms like “negative amortization,” “deferred interest,” or “payment options.” If you can make a payment that is less than the interest charged, your loan has this feature.
What should I do if my mortgage has this feature?
If you have an older Adjustable-Rate Mortgage (ARM) with this feature, avoid making only the minimum payment if possible. Contact your lender or a HUD-approved housing counselor to discuss your options, which could include a mortgage refinance into a stable, fixed-rate loan.