What is Negative Amortization?
Negative amortization occurs when your monthly loan payment is less than the interest owed on the loan. Instead of reducing your principal balance, the unpaid interest gets added to the total amount you owe. This means your loan balance grows over time, even though you’re making payments.
This situation typically happens with adjustable-rate mortgages or payment-option loans where borrowers can choose to make minimum payments that don’t cover the full interest due.
How Does Negative Amortization Work?
Negative amortization works through a payment structure that allows borrowers to make payments below what’s needed to cover accruing interest. When you make these reduced payments, the lender calculates the difference between what you paid and what you actually owe in interest.
That difference doesn’t disappear. Instead, it gets capitalized, meaning it’s added to your outstanding principal balance. As your principal grows, future interest charges are calculated on this higher amount, creating a compounding effect.
Most loans with negative amortization features have caps that limit how much the balance can grow, typically 110% to 125% of the original loan amount. Once you hit that cap, the loan automatically resets to require fully amortizing payments.
The Negative Amortization Formula
The formula for calculating negative amortization involves comparing the actual payment to the interest due:
Negative Amortization Amount = Interest Accrued – Payment Made
New Loan Balance = Previous Balance + Negative Amortization Amount
For example, if your loan accrues $1,500 in interest for the month but you only pay $1,000, the $500 difference is added to your principal. If your previous balance was $300,000, your new balance becomes $300,500.
Real-World Application of Negative Amortization in Real Estate
In real estate, negative amortization most commonly appears in option-ARM (adjustable-rate mortgage) products. Investors and homebuyers who expect significant income increases or plan to refinance or sell quickly might choose these loans for initial payment flexibility.
Real estate investors sometimes use negative amortization loans when purchasing properties they intend to renovate and flip within a short timeframe. The lower initial payments free up cash for renovations while they work on the property.
However, during the 2008 financial crisis, many borrowers found themselves owing more than their homes were worth, partly due to negative amortization features combined with declining property values. This created situations where homeowners couldn’t refinance or sell without bringing cash to closing.
How Negative Amortization is Used
Negative amortization is used as a cash flow management tool, particularly by borrowers who have irregular income streams or expect their earnings to increase substantially. Real estate agents and commissioned professionals sometimes prefer these loans because their income fluctuates seasonally.
Lenders use negative amortization structures to make loans more accessible by offering lower initial payments. Borrowers must explicitly choose the minimum payment option each month, as most payment-option loans offer several payment choices including fully amortizing payments.
Financial planners sometimes incorporate negative amortization strategically when clients have strong investment opportunities that could yield returns exceeding the loan’s interest rate. However, this approach carries significant risk if those investments underperform.
In Other Words
Think of negative amortization as paying your credit card’s minimum payment when it doesn’t even cover the interest charges. Instead of making progress on what you owe, you’re actually going backward. Your debt grows each month despite making payments.
It’s essentially borrowing more money each month without taking out additional funds. You’re deferring today’s interest charges to tomorrow, and that deferred interest then generates its own interest charges going forward.
