What is Negative Amortization?Written By: Ashley Sutphin
Amortization is a process when you pay down your loan balance with the use of fixed payments. These are often monthly payments. If you buy a home with a 30-year fixed-rate mortgage, you pay the same amount each month. Your loan balance and the interest costs will decline over time.
Your monthly payment in this situation is based on your loan balance, which is how much money youre borrowing. The length of time you take to repay a loan which is the term, factors into your monthly payments, as does your lenders interest rate they charge on the balance of your loan.
The calculation of a loan payment provides a payment thats fixed. You will completely pay off a loan at the end of the loan term, which is usually 15 or 30 years for a mortgage. Every payment includes two things. Theres the part of the payment covering interest on your debt. Then the second part of the payment goes towards reducing the loan balance or paying off your debt.
How Would Negative Amortization Work?
On some loans, you can opt to pay less than whatever the fully amortizing payment is. If you pay less than the interest charges for a given month or time, you have unpaid interest for that month. Then, because of that, the lender will add the unpaid amount to your loan balance.
If youre not paying enough to cover your interest charges, youre not making enough of a payment to pay down your loan balance. The result is owing more money each month. You dont get money from your lender, but your loan balance grows because youre adding interest charges every month.
Adding interest to the balance of a loan is also called capitalizing the interest.
The main reason for paying less is that its better for your cash flow.
Paying Off Your Loan
You have to pay your loan off eventually. To do that, you might make regular amortizing payments. These are higher than what they would have been from the original loan agreement because your loan balance goes up when you dont pay interest.
Another way to pay the loan is to refinance, and a third is to make a balloon payment.
Balloon payments are large payments due at the end of this type of loan. These loans structure earlier payments during your loan term to be smaller. Then, the later payments, but usually just the last one, are higher. Many homeowners will have plans to refinance as they reach their balloon payment or sell their homes before the loans maturity date. Some businesses will use balloon loans to get smaller upfront payments, covering short-term needs, and then pay the debt before the balloon payment.
Are These Loans Predatory?
Negatively amortizing loans is considered predatory, and some borrowers dont understand why they might be able to make lower payments than required.
The housing crisis in 2008 reflected the risks of negatively amortizing loans. A lot of homebuyers were overleveraged on their mortgages, so they were given a chance to make lower payments than what would cover their interest. Banks were already at that time giving subprime, risky mortgages. When interest rates rose, people who had mortgages found they couldnt make their full payments, so even though they were making payments, they ended up more in debt.
Most mortgages are self-amortizing. These loans are predictable and consistent.
There are states that, following the housing crisis in 2008, ended up banning negatively amortizing loans, and currently, there are stipulations as far as what loans can do this. Student loans are one of the most popular types of loans now that have negative amortization.
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