Negative Amortization Loans
Payments that don't keep up with interest charges
Negative amortization happens when the payments on a loan are smaller than the interest costs. The result is that the loan balance increases as lenders add unpaid interest charges to the loan balance. Eventually, that process can lead to bigger payment requirements when it's time to pay off the loan.
Negative amortization is possible with any type of loan, and you might see it with student loans and real estate loans.
How Does Amortization Work?
To understand negative amortization, it's helpful to review the standard amortization process—and then compare and contrast.
Amortization is the process of paying down a loan balance with fixed payments (often monthly payments). For example, when you buy a home with a 30-year fixed-rate mortgage, you pay the same amount every month—even though your loan balance and interest costs decrease over time.
Monthly payments are calculated based on several factors:
- The loan balance, or how much money you borrow
- The length of time you take to repay the loan (known as the term)
- The interest rate your lender charges on your loan balance
Loan payment calculations provide a fixed payment that will completely pay off your loan at the end of the time period you choose (typically 15 to 30 years for a home loan). Each payment has two components:
- Part of the payment covers interest charges on your debt.
- The remainder of the payment goes toward reducing your loan balance (or paying off your debt).
To learn more about that process, see the sample amortization table at the bottom of this page.
How Negative Amortization Works
With some loans, you can choose to pay less than the fully amortizing payment.
When you pay less than the interest charges in any given month (or whatever time period applies), there’s unpaid interest for that month. As a result, your lender adds that unpaid amount to your loan balance.
If you don’t pay enough to cover interest charges, your payment is also not sufficient to pay down your loan balance. As a result, you owe more on your loan every month. You don’t receive any money from your lender, but your loan balance grows because you’re adding interest charges each month.
The process of adding interest to a loan balance is also known as capitalizing the interest.
The main reason to pay less is, not surprisingly, because it’s easier on your cash flow to do so.
Eventually, you’ll have to pay off the loan, which you can accomplish in several ways:
- Through regular amortizing payments (which will be higher than they would have been given the original loan arrangement—because your loan balance increases when you don't pay interest)
- By refinancing the loan
- By making a balloon payment to pay off the debt
Unable to Pay
Sometimes, you simply don’t have the funds available to make big monthly payments. For example, during periods of unemployment, you might not be able to pay your student loans. With federal student loans, it may be possible to apply for deferment, which allows you to stop making payments temporarily.
However, interest still applies to the loan balance, and you will be responsible for the interest unless you have subsidized loans (where the government pays those costs for you).
You often have the option to pay the interest—while skipping the larger payment—if you want to avoid negative amortization.
In some cases, investors prefer to avoid large monthly payments. That’s especially true for short-term projects (for example, a fix-and-flip). This is a speculative and risky way to invest, but some people and businesses do it successfully. For the strategy to pay off, you need to sell the property with enough profit to pay off the interest you never paid.
“Stretching” to Buy
Some home buyers use negative amortization to buy a property that is currently out of their price range. The assumption is that they’ll have more income later, and they’d rather buy a more expensive property today than buy a cheaper one (and have to move again later when they grow out of the property). Again, this is a risky strategy—you can’t predict the future, and there are countless stories of expectations that never became a reality. Some examples of risky loans include option-ARM loans or “pick-your-payment” loans (which are not as readily available as they used to be).
Example of Negative Amortization
To see negative amortization in action, take any loan and assume that you pay less than the interest charges. Over time, the balance will increase.
For example, assume you borrow $100,000 at 6% for 30 years to be repaid monthly. In this case, you pay nothing each month, and you see that the loan balance increases. You can build your own amortization tables and use any payment, balance, or rate you choose.
As you can see, the amount of interest you pay increases each month—along with your loan balance (known as the principal).
|Sample Table With Negative Amortization|
|Month||Beginning Balance||Payment||Principal Payment||Interest Cost||Ending Balance|
|1||$ 100,000.00||$ -||$ (500.00)||$ 500.00||$ 100,500.00|
|2||$ 100,500.00||$ -||$ (502.50)||$ 502.50||$ 101,002.50|
|3||$ 101,002.50||$ -||$ (505.01)||$ 505.01||$ 101,507.51|
|4||$ 101,507.51||$ -||$ (507.54)||$ 507.54||$ 102,015.05|
|5||$ 102,015.05||$ -||$ (510.08)||$ 510.08||$ 102,525.13|
|6||$ 102,525.13||$ -||$ (512.63)||$ 512.63||$ 103,037.75|
|7||$ 103,037.75||$ -||$ (515.19)||$ 515.19||$ 103,552.94|
|8||$ 103,552.94||$ -||$ (517.76)||$ 517.76||$ 104,070.70|
|9||$ 104,070.70||$ -||$ (520.35)||$ 520.35||$ 104,591.06|
|10||$ 104,591.06||$ -||$ (522.96)||$ 522.96||$ 105,114.01|
|11||$ 105,114.01||$ -||$ (525.57)||$ 525.57||$ 105,639.58|
|12||$ 105,639.58||$ -||$ (528.20)||$ 528.20||$ 106,167.78|
Consumer Financial Protection Bureau. "What Is Amortization and How Could It Affect My Auto Loan?" Accessed Jan. 14, 2021.
Consumer Financial Protection Bureau. "How Do Mortgage Lenders Calculate Monthly Payments?" Accessed Jan. 14, 2021.
Consumer Financial Protection Bureau. "What Is Negative Amortization?" Accessed Jan. 14, 2021.
U.S. Department of Education. "Student Loan Deferment Allows You to Temporarily Stop Making Payments." Accessed Jan. 14, 2021.