Negative amortization occurs when the monthly payments on a loan are insufficient to cover the interest charges, resulting in the unpaid interest being added to the loan balance. As a result, the outstanding balance of the loan may increase over time instead of decreasing, even though the borrower is making regular payments. Negative amortization is commonly associated with certain types of adjustable-rate mortgages (ARMs) or interest-only loans, where the initial payments are set at a level lower than the fully amortizing payment required to pay off the loan over its term.
Mortgage with negative amortization represents a particular type of loan that initially allows borrowers to make lower monthly payments that do not cover the full amount of interest due. As a result, the unpaid interest is added to the principal balance of the loan, causing the total amount owed to increase over time, rather than decrease. While this type of mortgage can seem attractive due to its initially lower payment requirement, it carries significant risks and complexities.
Reasons Borrowers Might Choose a Negative Amortization Mortgage
**1. Lower Initial Payments
- Cash Flow Management: Borrowers who expect their incomes to increase in the future but currently have limited cash flow may opt for a mortgage with negative amortization to keep their initial housing costs low.
- Investment Strategy: Some borrowers may prefer to free up cash for other investments, such as starting a business or investing in the stock market, expecting higher returns than the cost incurred by the increasing loan balance.
**2. Entry into Higher-Priced Markets
- Access to Desirable Properties: In high-cost real estate markets, negative amortization loans can make homeownership more accessible by reducing initial monthly payments, allowing borrowers to buy homes they otherwise could not afford.
Risks Associated with Negative Amortization Mortgages
**1. Increasing Debt Load
- Growing Loan Balance: The most significant risk of negative amortization is that the loan balance grows over time. If the property value does not appreciate, this can lead to the borrower owing more on the mortgage than the home is worth, a situation known as being "underwater" on a mortgage.
**2. Payment Shock
- Adjustment Period: Negative amortization loans typically have a reset point where the payment increases significantly. This can happen either when the negatively amortizing period ends or when the loan balance reaches a certain threshold. This payment increase can be a shock to borrowers if they are not financially prepared.
**3. Property Depreciation
- Market Risk: If the housing market declines, borrowers might find themselves with a loan balance that exceeds the value of the home, making it difficult to refinance or sell the property without incurring a loss.
**4. Complexity and Misunderstanding
- Product Complexity: Negative amortization loans can be complex and difficult for some borrowers to fully understand. There is a risk that borrowers may not be fully aware of how quickly their loan balance can increase or the implications of such increases.
**5. Long-Term Financial Impact
- Equity Building: Borrowers with negative amortization loans typically build equity at a slower pace than those with traditional amortizing loans, which can affect their long-term financial stability and wealth accumulation.
Conclusion
Choosing a mortgage with negative amortization might seem appealing due to the low initial payments, especially for borrowers expecting future income growth or those aiming to enter high-cost housing markets. However, the risks associated with these loans are significant. They include the potential for substantial increases in the loan balance, payment shocks after reset periods, difficulties in building home equity, and the possibility of ending up with a loan that exceeds the home's value. Borrowers considering this type of mortgage should carefully assess their future financial stability and understand the loan terms and conditions to ensure they can handle potential increases in payments and the growing debt balance.