Amortization is the process of making payments on a loan and gradually reducing the balance. With a negative amortization loan, even if you make payments, the balance you owe can continue to grow.
How a Negative Amortization Loan Works
When you take out a mortgage, you usually have to make monthly payments that cover both interest and a portion of the principal. As the years go by, you gradually pay down the principal.
With a negative amortization loan, you make monthly payments, but they only cover some of the interest owed. The interest that you don’t pay gets added to the principal balance, and you get charged interest on the unpaid interest. That means that over time, your loan balance keeps growing and growing, even if you make regular monthly payments.Â
A payment option adjustable-rate mortgage can let you decide how much of the interest due you want to pay each month. Unpaid interest is tacked onto the principal balance.Â
With a graduated payment mortgage, your early payments only cover a portion of the interest owed, and unpaid interest is added to the loan balance. Later on, you have to begin making full interest payments each month.
Understand the Risks of Negative Amortization Loans
A negative amortization loan may seem attractive at first, especially if you have a low income or poor credit. It can allow you to purchase a house or get a larger mortgage than you might otherwise qualify for and make low monthly payments.Â
Negative amortization can’t go on forever. At some point, the payments will be recalculated, and you will have to pay off both the principal and interest. That may happen after a set number of months, or it may happen when the total principal balance reaches a predetermined threshold. When the payments are recalculated, the amount you owe each month can skyrocket.
If you can’t keep up with the payments, you can wind up in foreclosure. Even if you can cover the higher interest payments later on, you will pay a lot more in interest with a negative amortization loan than you would pay with a mortgage that requires full interest payments each month.Â
Your loan balance can wind up being higher than the value of the house. You may find it difficult or impossible to sell the house and pay off the mortgage if you owe more than the property is worth.Â
The federal government considers negative amortization loans to be predatory, and a number of states have banned them. Before you consider a negative amortization loan, or any type of mortgage, carefully read over all the terms and ask questions about anything you don’t understand. Explore mortgage options from a variety of lenders and steer clear of a loan that seems too good to be true.
