Negative Amortization Explained
Negative amortization is a scary sounding term that represents a simple concept. When you pay less than the interest payment on a mortgage, then any shortfall is added to your mortgage.
For example:
-an interest only payment for a mortgage is $2,000 per month
-paying at the interest-only payment level keeps the loan size the same (the principal, or loan balance, remains the same)
-a minimum payment option loan allows a borrower to pay as low as $1,600 per month
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-the borrower makes the minimum payment of $1,600
-there is a $400 shortfall ($2,000 less $1,600)
-the shortfall is added onto the loan so that loan size is increasing
-this is known as negative amortization
Advantages of Negative Amortization
The advantage of negative amortization is that you are keeping your money in your bank account rather than paying your mortgage down. For example:
-if you buy a house for $300,000 with a regular loan at 6% interest your pay about $1,800 per month
at the end of the year your loan balance has only decreased by around $4,000 dollars
most of your money has gone to paying interest
-if the value of your property has increased by 10% for the year then your house is worth $330,000
-at the end of the year you have about $34,000 in equity in your property ($330,000 less your remaining loan balance of $296,000)
-almost all of your equity in this example was built by market gains, not by paying down the loan
-if you had a negative amortization loan on the property then the loan balance may have actually increased
-if your property has appreciated faster than this you are still building equity in your property
Disadvantages of Negative Amortization
Negative Amortization also has drawbacks. If the loan balance increases while the market value of the property remains the same or declines then equity in being wiped out. You can end up owing more money on the loan than the property is worth.
Having negative equity can also happen with a regular loan that doesn't have negative amortization, so it is not a risk unique to these types of loans.
A traditional mortgage can also act as a form of "forced savings". With negative amortization people may keep more of their money. They can also spend it instead of saving it.
Loans that offer negative amortization as an option can have substantially lower monthly payments than regular mortgage loans.
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