What is Negative Amortization?
Negative Amortization Explained
Despite that, some loans are negatively amortizing, meaning that the borrower is making payments that are actually less than the interest owed on the loan. For instance, if the monthly interest payment on a loan was $300, and the loan allowed a borrower to only pay $200 during that period, it would amortize negatively.
This means that the principal owed on the loan increases over time -- which can often leave borrowers in a sticky position when it comes time to pay up.
What Kinds of Loans are Negatively Amortizing
Here are examples of loans that have negative amortization:
These home loans typically involve 5 to 7 years of payments at a 30-year fixed rate, after which a large payment (the remaining principal of the loan) is due. Balloon mortgages sometimes allow payments that are lower than the interest, therefore becoming negatively amortizing.
Payment Option ARMs
This is a kind of home loan where there are several payment options, including a fully amortizing payment option, an interest-only payment option, and a minimum payment option. The minimum payment option typically involves negative amortization
Graduated Payment Mortgages (GPMs)
These mortgages have payments that increase slowly over time, and are usually taken out by borrowers who believe their income will increase significantly in the next few years. In the beginning years of a graduated payment mortgage, the payments are often negatively amortizing, after which they slowly transition to becoming fully amortizing payments.
The Risks of Negative Amortization
While negative amortization loans have the benefit of reducing your payments in the short run, they do have risks. Negative amortization increases the principal of your loan, and you’ll eventually have to pay all of that back (with interest, of course.)
Negative amortization can be even riskier if it’s followed by a steep decline in the value of your home. This makes it far easier to “go underwater” on your mortgage -- meaning that you currently owe more than the home is worth.
For example, imagine you owed $180,000 on a home worth $200,000. Due to negative amortization, you now owe $190,000. Next, the value of your home drops to $185,000, meaning you’d be $5,000 underwater on your mortgage. Being underwater makes it particularly hard to get your home refinanced in order to reduce your mortgage payments, and, if you fall behind, you could default on your home loan.
That’s why it’s always essential to approach any kind of negatively amortizing loan with a lot of caution -- and to only take one on when you fully understand the risks and benefits of this kind of financial arrangement.
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