What is Negative Amortization?

A negative amortization loan is a home loan where the loan balance increases over time. This is in contrast to traditional mortgage loans, where in your monthly payments and interest rate are set such that you will eventually pay down or pay off the loan within a certain period of time — usually 30 years. Negative amortization typically occurs for normal homeowners as a result of an adjustable rate mortgage (ARM). For example, many ARMs come with a monthly mortgage payment cap that prevents the homeowner from owing more than a certain amount each month. When the ARM adjusts to a higher interest rate, your capped monthly payment may not be enough to cover both the interest expense and a principal payment. When this occurs, the shortage towards your monthly interest expenses is simply tacked on to your loan balance.

There are obvious pros and cons to a negative amortization loan, whether you find yourself in one by design or by accident. As a homeowner with an ARM and a capped monthly payment, you can be assured that you won’t be forced into default or foreclosure simply because the interest rate has increased drastically. Along those same lines, the lender can offer you a better initial interest rate because there is a profitable means for them to pass along higher interest rates to you (as opposed to a fixed rate mortgage, where the lender essentially has the eat the costs of an increased interest rate). However, depending on how interest rates and home market values perform over time, you could see yourself upside down or underwater on your home mortgage down the road. That is, when you owe more on your home mortgage than your home is worth. In these cases, you may not be able to pay off your home mortgage from the proceeds of your home sale.

For most homeowners, negative amortization situations are neither expected nor favorable. If you find yourself creeping into a negative amortized home loan, it may be time to take swift and decisive action towards refinancing your mortgage. If you are not eligible for a mortgage refinance due to loss of income or a poor credit score, you may be able to pursue a loan modification or some other type of home mortgage relief through your lender or a government sponsored program.

On the other hand, for some homeowners, a negative amortization loan may make sense. For example, the FHA sponsors a reverse mortgage program than allows senior citizens to draw down equity in their home for as long as they occupy it. Each month, their outstanding loan balance grows larger, but given their needs, this may be a suitable and sustainable source of income.

Real estate investors or others who may be looking to take aggressive positions on real estate may also be able to use a negative amortization loan to their advantage, either by using it as a bridge loan or hard money loan or by using it to tap the equity in their property. These decisions should never be made lightly, however, and should be discussed with a financial advisor and a qualified mortgage broker.