What Is Negative Amortization and How It Affects Loans?

Amortization is the process of paying off a loan over time through regular, scheduled payments. Each payment typically includes a portion that covers the interest accrued and a portion that reduces the outstanding principal balance. This systematic reduction of debt is how most loans are structured. However, an exception to this standard repayment process is negative amortization, where the loan balance can actually increase even while payments are being made.

Defining Negative Amortization

Negative amortization occurs when a borrower’s scheduled loan payment is less than the amount of interest that accrues on the loan during that payment period. Rather than the principal balance decreasing with each payment, the unpaid interest is added to the loan’s principal. This means that the total amount owed on the loan grows larger over time.

Common Loan Structures

Negative amortization is most frequently found in certain types of mortgage loans, particularly adjustable-rate mortgages (ARMs) that feature payment caps or deferred interest options. These ARMs might offer an initial low minimum payment that does not fully cover the interest due. The purpose of such a feature is often to provide payment flexibility or a lower initial payment, rather than to increase overall affordability in the long run.

Some student loan repayment plans, specifically income-driven repayment (IDR) plans, can also lead to negative amortization. In these plans, monthly payments are based on income, and for borrowers with low earnings, the payment might not be sufficient to cover all accruing interest. The interest that is not covered by the payment is then capitalized, adding to the principal balance.

How Loan Balances Change

When negative amortization is in effect, the detailed mechanics involve the shortfall between the interest owed and the payment made being added directly to the principal. For example, if a borrower owes $800 in interest for a given month but only makes a payment of $500, the remaining $300 in unpaid interest is added to the loan’s principal balance. This process is often referred to as deferred interest. Consequently, the loan balance grows larger, and subsequent interest calculations are then based on this new, higher principal amount. The implication is that even though a borrower is making payments, they are not making progress in reducing their debt and may, in fact, owe more than the original amount borrowed.

Over time, this can significantly extend the repayment period of the loan and lead to a much higher total repayment amount. Lenders typically include a “recast” period in such loans, often around five years, or a negative amortization limit, such as 110% to 125% of the original loan amount. Once these limits are reached, the loan payments are recalculated to fully amortize the new, higher balance, which can result in a substantial increase in monthly payments.

Identifying Negative Amortization

Borrowers can determine if their loan has a negative amortization feature or if they are currently experiencing it by reviewing their loan documents. Key terms to look for include “negative amortization,” “payment cap,” “deferred interest,” or “minimum payment option.” These terms indicate that the loan structure allows for payments that may not cover all accrued interest.

Regularly examining monthly loan statements is another practical step. If the principal balance on the statement is increasing despite consistent payments, it indicates that negative amortization is occurring. Understanding these indicators allows borrowers to be aware of the dynamics of their loan and take appropriate action if necessary.