Negative Amortization Loans

When payments don't keep up with interest

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Negative amortization happens when the payments on a loan are not large enough to cover the interest costs. The result is a growing loan balance, which will require larger payments at some point in the future.

Negative amortization is possible with any type of loan, and it is often seen with student loans and real estate loans.

How does negative amortization work?

To understand negative amortization, it’s best to start with plain-old amortization. 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’ll make the same payment every month – even though your loan balance and your interest costs decrease over time.

Monthly payments are calculated based on several factors:

A calculation comes up with 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:

  1. Part of the payment covers interest charges on your debt
  2. The remainder of the payment pays down your debt (or reduces your loan balance)

To learn more and see sample amortization tables, At the bottom of this page, you’ll find a sample negative amortization chart.

When things go negative

With some loans, you have the ability to pay less than the fully amortizing payment. The main reason to pay less is, of course, it’s easier to pay less.

When you pay less than the interest charges in a given month (or whatever time period applies), interest costs are added to your loan balance. In other words, you owe more every month. You don’t actually receive money from your lender, but your loan balance grows because you’re not paying interest.

The process of adding interest to a loan balance is known as capitalizing the interest.

Eventually, you’ll have to pay off the loan. That can happen in several ways:

Why use negative amortization?

You’ve got to pay either way, so why do people choose to let loans grow?

Inability to pay: sometimes you simply don’t have the funds available to make payments. For example, during periods of unemployment, you might not be able to pay your student loans. It’s possible to apply for deferment, which allows you to stop making payments temporarily. However, interest is still charged, and you’ll have to pay the interest unless you have subsidized loans. Note that you often have the option to pay the interest (while skipping the larger payment) if you want to avoid negative amortization.

Investor loans: in some cases, investors are not interested in signing up for large monthly payments. This is 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 asset 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 at some point in the future. 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 popular 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, we’ll pay nothing each month, and you’ll see that the loan balance increases. You can build your own amortization tables and use any payment you choose.

As you can see, the amount of interest you pay increases each month – along with your loan balance.

Month Beginning Balance Actual Payment Principal Interest 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