Meta-title: Negative Amortization Explained: Loan Balance Grows Despite Payments
Meta-description: Understand negative amortization, where your loan balance increases even with payments, often seen in ARMs. Learn how it impacts borrowers.
Overview:
Negative amortization is a loan situation where your payments aren’t large enough to cover the interest charged, causing the unpaid interest to be added to your loan’s principal balance. This means you owe more over time, even though you’re making payments.
Why Does My Loan Balance Increase Even When I’m Paying It?
Definition:
Negative amortization occurs when a loan’s periodic payment is insufficient to cover the interest due for that period. The shortfall is then added to the outstanding principal balance, increasing the total amount owed. This is often seen in specific types of adjustable-rate mortgages (ARMs) or with other loan products that offer payment caps.
Negative Amortization: When Your Loan Grows Larger
Background/History
The concept of negative amortization gained prominence in the U.S. housing market during the early 2000s, particularly with the rise of Adjustable-Rate Mortgages (ARMs). Lenders offered ARMs with features like low initial “teaser” rates and payment caps that allowed borrowers to pay less than the full interest due. While this made homes more accessible initially, it led to a situation where borrowers’ loan balances could actually increase over time, a phenomenon that contributed to the mortgage crisis of 2008.
How It Works
Most loans, like a standard mortgage, are fully amortizing. This means each payment covers both the interest accrued and a portion of the principal. Over time, the principal balance decreases.
With negative amortization, the payment made doesn’t cover the full interest. For example, if your loan accrues $500 in interest in a month, but your payment is only $400, the remaining $100 in interest isn’t paid. Instead, that $100 is added to your principal balance. So, if your starting principal was $200,000, after one month, you’d owe $200,100, even though you made a $400 payment. This process can continue, snowballing your debt.
Real-World Examples
- Option ARMs: These were popular mortgages that allowed borrowers to choose their payment amount from several options each month. One option might be a minimum payment that didn’t even cover the interest, leading to negative amortization.
- Graduated Payment Mortgages (GPMs): These loans start with lower payments that gradually increase over time. In the early years, payments might be too low to cover interest, resulting in negative amortization.
- Loan Assumptions: If you assume a loan with a below-market interest rate, and the payments are calculated based on that low rate, negative amortization can occur if the loan’s actual interest accrual is higher.
Who It Affects
Negative amortization primarily affects borrowers who take out loans with features that allow for it, most commonly certain types of ARMs or specialized loan products. It can also affect those who assume existing loans with favorable-to-them interest rates.
Tips or Strategies
- Understand Your Loan Agreement: Always read and fully comprehend the terms of your loan, especially if it’s an ARM. Look for any mention of “payment caps” or “negative amortization.”
- Avoid If Possible: For most borrowers, especially first-time homebuyers, fully amortizing loans with predictable payments are generally safer.
- Recast Your Mortgage: If your loan allows for it and your balance has grown due to negative amortization, you may be able to “recast” the loan. This means recalculating the payment based on the new, higher principal balance over the remaining loan term, often resulting in a higher but stable monthly payment.
- Make Additional Principal Payments: If you have a loan that allows negative amortization but you want to counteract it, consider paying more than your required payment to ensure all interest is covered and principal is reduced.
Common Misconceptions
- “My payments are going up, so I must be paying down principal.” Not necessarily. If your payment increases because the interest rate went up, but the new payment is still less than the interest due, your principal balance can continue to grow.
- “Negative amortization only happens with adjustable-rate mortgages.” While ARMs are the most common place to find it, other loan types, like certain GPMs, can also feature negative amortization.
Sources:
- Consumer Financial Protection Bureau (CFPB) – Adjustable-Rate Mortgages (https://www.consumerfinance.gov/owning-a-home/home-loans/adjustable-rate-mortgages/)
- Investopedia – Negative Amortization (https://www.investopedia.com/terms/n/negative-amortization.asp)
- Kiplinger – Should You Use a Negative Amortization Mortgage? (https://www.kiplinger.com/article/mortgages/a003-c003-003-should-you-use-a-negative-amortization-mortgage.html)