When the amount that you owe on a loan increases despite regular monthly payments
Negative amortization typically happens with an adjustable rate mortgage (ARM) that has a payment cap. This means that your monthly payment can only increase up to 7.5% from the last adjustment period.
Here's how this type of loan works: the lender gives you three options on how to pay your monthly loan payment. Typically, you can pay (1) the full amount that's due, which covers both the principal and interest (2) the amount based on the payment cap or (3) interest only.
If you select the second method, you're at risk of negative amortization - if the loan's interest rate shoots up, you owe more money than what the payment cap accounts for. This unpaid interest is then tacked onto your loan. So, your loan balance creeps up instead of shrinking. Similarly, with the third method, the amount that's not paid on the principal is added to your loan.
This type of loan makes sense for people and companies who have seasonal or staggered incomes, or for people who want more flexibility and can manage their finances with daily updated spreadsheets.
Example: How can negative amortization occur on an ARM that has a payment cap of $500?
$200,000 ARM at 8% interest
|Payment option||How much
|Amount added to
|1. Full payment||$712||$0|
|2. Payment cap||$500||$712 - 500 = $212|
|3. Interest-only payment||$600||$712 - 600 = $112|
With option 2, the $212 difference between the full payment and the payment cap is added to your loan principal, causing negative amortization. Option 3 also results in negative amortization since the $112 difference between the full payment and the interest-only payment is added to your loan.
See: Adjustable rate mortgage, Payment cap