Definition:
Negative amortization occurs when the monthly payments on a mortgage are not sufficient to cover the interest charges. As a result, the unpaid interest is added to the principal balance, causing the loan balance to increase over time rather than decrease. This can lead to a situation where the borrower owes more than the original amount borrowed, even though they’ve been making payments.
How negative amortization works
In a typical mortgage, your monthly payments are applied toward both the interest and the principal balance. However, with negative amortization, the payments you make are less than the interest due on the loan, meaning that the shortfall gets added to the principal. Over time, this can cause the loan balance to grow, which can be a risk if the borrower doesn’t adjust their payments.
Types of mortgages that allow negative amortization
Certain types of mortgages are more likely to result in negative amortization, including:
- Interest-only mortgages: In these loans, the borrower only pays the interest for a set period, typically 5–10 years, with no payments toward the principal. If the interest rate increases, it can lead to negative amortization.
- Option ARMs (Adjustable Rate Mortgages): These offer borrowers several payment options, including a minimum payment that may not cover the interest. This can lead to negative amortization, especially if interest rates rise.
Risks of negative amortization
Negative amortization can be a risky financial situation for homeowners. The primary risks include:
- Increasing debt: As the loan balance grows, it becomes more difficult to repay the mortgage, especially if property values fall or interest rates rise.
- Longer repayment periods: Negative amortization extends the length of time it will take to pay off the loan, making it harder to build equity in the property.
- Higher future payments: Once the negative amortization period ends, the borrower may face higher monthly payments to repay the larger loan balance.
Why negative amortization might occur
Negative amortization can happen for a variety of reasons, including:
- Low initial payments: Some mortgage products offer low initial payments that don’t cover the interest in the early years of the loan.
- Adjusting interest rates: If you have an adjustable-rate mortgage (ARM), increasing interest rates can lead to higher monthly payments, which may not be sufficient to cover the full interest cost.
- Financial hardship: In some cases, borrowers may choose to make lower payments during times of financial stress, inadvertently allowing negative amortization to occur.
How to avoid negative amortization
To avoid the pitfalls of negative amortization, consider these strategies:
- Make higher payments: If possible, pay more than the minimum monthly payment to cover both the interest and principal.
- Refinance your mortgage: Refinancing to a fixed-rate mortgage or one with better terms can help you avoid negative amortization.
- Monitor interest rate changes: If you have an adjustable-rate mortgage, be aware of interest rate changes and adjust your payments accordingly.
- Understand your mortgage terms: Know how your mortgage works, particularly if it includes any payment options that could result in negative amortization, and ask your lender about your options.
The impact of negative amortization on your finances
Negative amortization can have long-term financial consequences. It can affect your ability to sell or refinance your home, as lenders may be unwilling to lend on a property with a higher-than-expected loan balance. Additionally, it can prevent you from building equity in your home, as the principal is not being reduced.
Getting professional advice
If you’re concerned about negative amortization or if you’re unsure whether it applies to your mortgage, it’s important to consult a mortgage broker or financial advisor. They can help you understand your mortgage terms, explore options for refinancing, and develop a strategy to manage or avoid negative amortization.
Last modified: November 11, 2024
