What Is a Negative Amortization Mortgage?

Mortgages typically involve a structured repayment plan where debt gradually decreases over time. While most mortgages follow a standard amortization schedule, negative amortization is a less common loan characteristic. This feature alters the typical repayment process, leading to outcomes that differ from traditional mortgage structures. Understanding how this concept functions within certain loan products helps borrowers navigate home financing options.

Understanding Negative Amortization

Negative amortization occurs when the scheduled payment on a loan is not enough to cover the full amount of interest accrued for that payment period. Instead of the loan principal decreasing, the unpaid interest is added back to the original principal balance. This process results in the total amount owed on the mortgage actually increasing over time, even though regular payments are being made.

This situation contrasts sharply with conventional mortgages where a portion of each payment goes towards reducing the principal balance, alongside the interest payment. In a negatively amortizing loan, the borrower’s payments fall short of the interest due, causing the principal to grow. This means the borrower ends up owing more than the initial amount borrowed, despite consistently making their required payments.

Mechanics of Negative Amortization

Negative amortization involves a straightforward mechanism: when the required monthly mortgage payment is less than the interest accrued, the difference is capitalized. Uncollected interest is added directly to the outstanding principal balance. Consequently, the loan balance grows with each payment that does not fully cover the interest.

For instance, if a borrower owes $1,000 in interest but their minimum payment is $800, the remaining $200 is added to the principal. The following month, interest is calculated on this new, higher principal amount, perpetuating the cycle of increasing debt if payments remain insufficient. This differs from a standard amortizing loan, where each payment covers the full interest due and reduces principal. The borrower pays interest on a continually growing principal, which includes previously unpaid interest.

Mortgage Products with Negative Amortization Features

Negative amortization is typically found in specific loan structures offering payment flexibility or lower initial payments. A common example is the payment-option adjustable-rate mortgage (ARM). These loans allow borrowers to choose from several monthly payment options, including an interest-only payment, a fully amortizing payment, or a minimum payment less than the accrued interest. When a borrower consistently selects the minimum payment, negative amortization can occur because it may not cover the full interest due.

Another mortgage type that historically incorporated negative amortization is the graduated payment mortgage (GPM). These loans feature lower initial payments that gradually increase over time, often aligning with anticipated income growth. In a GPM’s early years, scheduled payments might be below the actual interest accruing, leading to negative amortization until payments increase sufficiently to cover interest and begin reducing principal. While offering initial payment relief, these products carry the potential for the loan balance to increase before it declines.

Implications for Your Mortgage

Negative amortization carries several important consequences for a borrower’s mortgage. The most direct impact is an increasing loan balance, meaning the amount owed grows larger despite regular payments. This escalating principal can reduce or even eliminate a borrower’s equity if the loan balance exceeds the home’s market value. This scenario, often called being “underwater,” complicates selling the property, as the sale price may not cover the outstanding debt.

Another significant outcome is the potential for “payment shock” when the loan reaches a recast point or resets. Lenders typically limit how much a loan balance can increase due to negative amortization, or set specific intervals for payment recalculation. At these points, the loan is re-amortized based on the higher outstanding balance and remaining term, resulting in a substantially higher monthly payment. This unexpected increase can strain a borrower’s budget, potentially making the mortgage unaffordable. Over the loan’s full term, the total cost of borrowing also increases as more interest accrues on the growing principal.

Addressing Negative Amortization

For borrowers facing or considering a mortgage with negative amortization, proactive management can mitigate its effects. One strategy is to consistently pay more than the minimum required payment, specifically enough to cover at least the full interest accrued each month. This ensures the loan balance does not increase and can begin to amortize normally. Making additional principal-only payments can further accelerate the reduction of the loan balance.

Regularly reviewing mortgage statements helps monitor the loan balance and how payments are applied. If the loan balance is increasing, communicating with the lender to discuss payment options or potential loan modifications can provide solutions. In some cases, refinancing into a traditional, fully amortizing mortgage, such as a fixed-rate loan, can eliminate negative amortization and provide payment stability.