What Is Negative Amortization?
We usually think of mortgages as debts that are paid off over time. This happens because monthly payments usually cover interest costs and a reduction of principal. Loans that are re-paid over their terms are called “amortizing” or “self-amortizing.”
With some adjustable-rate mortgages (ARMs), however, we can have a situation where monthly payment increases are limited. At the same time, it is possible for interest rates to rise enough so that monthly payments do not cover monthly interest costs. Example, the monthly payment is $1,500 but the monthly interest cost is $1,700.
Some loans permit negative amortization. In this case, the monthly payment would be $1,500, the interest cost would be $1,700, $1,500 in interest would be paid off with the monthly payment, and $200 would be added to the mortgage debt. Increasing the size of the loan balance is called “negative amortization.” If the loan term ends without sufficient amortization, the remaining debt could be larger than the original mortgage amount.
Negative amortization can generally be off-set by increasing monthly payments. Also, ARM loans typically limit the amount of negative amortization to 125 percent of the original loan amount. If the debt increases to 125 percent of the original loan amount than the lender can call the loan unless the borrower pays down a portion of the debt or makes other arrangements with the lender.
Borrowers are advised to carefully review all terms associated with any loan program. Combine a loan with negative amortization with falling home values and such mortgages are enormously difficult — if not impossible — to refinance. The common result can be foreclosure and bankruptcy.
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