Negative Amortization
Definition and meaning of Negative Amortization in real estate.
Negative amortization occurs when the scheduled monthly payment on a loan is smaller than the interest charged during that period, causing the unpaid interest to be added to the principal balance. This process increases the total debt owed by the borrower over time, rather than reducing it.
In more detail
This scenario typically arises with certain adjustable-rate mortgages or payment-option loans where borrowers are allowed to select a minimum payment. While this option offers temporary payment flexibility, it can lead to payment shock when the loan eventually recalculates to require full principal and interest payments.
Because the loan balance increases, the borrower loses equity in the home and may end up owing more than the property is worth. Many lenders and financial regulators discourage negative amortization loans due to the high risk of default.
Key facts
| Category | Mortgages & Financing |
|---|---|
| Risk factor | Increasing debt and loss of home equity |
| Typically found in | Payment-option adjustable-rate mortgages |
| Key outcome | Loan balance increases over time |
A borrower has a mortgage payment of $1,000, but the interest due that month is $1,200. The unpaid interest of $200 is added to the loan balance, causing the total debt to increase.
Frequently asked questions
How can I avoid negative amortization on my mortgage?
Choose a fixed-rate mortgage or make sure your monthly payments on an adjustable-rate mortgage are large enough to cover all the interest due each month.
What is payment shock in the context of these loans?
Payment shock happens when a mortgage must reset to fully amortize, resulting in a sudden and dramatic increase in the monthly payment that the borrower may not be able to afford.