Negative amortization refers to the phenomenon where the principal balance of a loan increases instead of decreases over time. This occurs because the payment made by the borrower is insufficient to cover the interest due, causing the unpaid interest to be added to the loan’s principal balance.
Mechanics of Negative Amortization
How It Works
In traditional amortization, the borrower makes regular payments that cover both the interest and a portion of the principal. However, with negative amortization, the payments are less than the interest owed. The unpaid interest is then capitalized and added to the loan’s principal balance. Mathematically, if \( P_t \) is the principal at time \( t \), \( r \) is the interest rate, and \( M \) is the monthly payment:
Calculation Example
Consider a borrower with a loan principal of $100,000 at an annual interest rate of 5%. If the monthly interest due is $416.67 and the borrower pays only $300, the unpaid interest of $116.67 is added to the principal. The new principal becomes:
Real-World Examples
Adjustable-Rate Mortgages (ARMs)
Negative amortization frequently occurs in Adjustable-Rate Mortgages where initial payments are low but increase over time. Borrowers may initially benefit from lower payments but face higher total debt over time if they do not pay sufficient amounts.
Graduated Payment Mortgages
In some graduated payment mortgages, negative amortization is used as a tool to make homeownership more accessible by starting with lower payments that increase over time.
Implications and Considerations
Benefits
- Initial Lower Payments: Borrowers might afford lower initial payments, making expensive assets like homes more accessible.
- Increased Cash Flow: Initially lower payments can provide temporary cash flow relief in times of financial strain.
Risks
- Increased Debt: The primary risk of negative amortization lies in the increased loan principal, which can trap borrowers under more debt than initially borrowed.
- Higher Future Payments: Eventually, payments will need to increase to cover the larger principal and interest.
Historical Context
Negative amortization became particularly prominent during the housing boom and subsequent bust in the mid-2000s. Many borrowers took on loans with artificially low initial payments, which later escalated, contributing to widespread defaults and foreclosures.
Comparison with Other Amortization Types
Positive Amortization
In positive amortization, each payment made reduces the loan’s principal, ensuring that over time, the borrower owes less.
Interest-Only Loans
In interest-only loans, the borrower pays only the interest for a specified initial period, then pays off the principal afterwards. This doesn’t raise debt as negative amortization does but delays repayment of the principal.
Related Terms
- Principal: The original sum of money borrowed in a loan.
- Amortization: The process of reducing debt through regular principal and interest payments over time.
- Interest Rate: The percentage charged on the total principal of a loan.
FAQs
What Causes Negative Amortization?
Is Negative Amortization Common?
Can Negative Amortization Be Avoided?
References
- “The Fundamentals of Loan Amortization” by J. Smith
- “Negative Amortization in Residential Mortgages” by L. Johnson
- Financial Industry Regulatory Authority (FINRA) website
Summary
Negative amortization is a financial phenomenon where a loan’s principal balance increases due to insufficient payments covering the interest due. While it may offer initial cash flow benefits, it also carries risks of higher future debt and payments. Understanding the mechanics, implications, and historical context of negative amortization is crucial for making informed financial decisions.
