Negative Amortization

Financial Dictionary -> Loans -> Negative Amortization

Generally, the mortgage payment a borrower makes each month is a pre-determined amount that covers the principal plus interest for that month. A negative amortization occurs when the borrower makes a payment that is less than the accrued interest and the difference is then added to the balance of the loan.

The term amortization by itself simply refers to the reduction in the loan balance; for instance, the amount of the loan that the borrower still owes the lender. The monthly payment the borrower makes has two parts to it, the interest due and the amortization of principal.

For a better understanding, take the following example:
- Monthly mortgage payment: $600
- Term of the loan: 30 years
- Fixed rate at 6% for a $100,000 loan

The payment for the first month includes an amount of $500 for interest alone. $100 is for the amortization of principal. Once that first monthly payment is made, the balance on the remainder of the loan would be $99,900. If the borrower made a payment (or payments) greater than $600 a month, the loan balance would be paid off in less than 30 years. In the same way, if the borrower made a payment (or payments) of less than $600 a month, the loan balance would not be paid off in 30 years.

If, in our example, a negative amortization was realized, it would mean the borrower had paid less than the amount that goes toward the interest. For instance, if the borrower made a $400 a month payment, it would not meet the amount of the principal by $100 and that amount would be added to the loan balance, making it in effect $100,100. The increase in the balance amount of the loan is negative amortization.

While we used a fixed-rate mortgage (FRM) for our example, negative amortization can occur with an adjustable rate mortgage (ARM) as well. It's sometimes used to create a smaller mortgage payment at the beginning of the loan contract. Something the borrower should realize when using negative amortization is that, while the beginning payments of their loan may be smaller, the payments will be increased later on their mortgage in order to fully amortize the loan.