What is negative amortization?
When choosing a loan structure program for purchasing a new home, often the biggest concern for homeowners is: "How much will my monthly payment be?" The answer to this question is a relatively variable one, depending on the loan program. But it's often the most important question to get answered before you even begin looking for a new home. How much you can afford for a monthly payment will determine how much house, and what type of loan structure, you'll qualify for. Yet the one question that often isn't asked-and probably should be-is: " What is negative amortization, and how can I avoid it?"
Amortization is the term used for describing the process of lowering the principal amount of your home loan. On most loan structures, as you make payments, the amount you pay applies partially toward the loan interest amount and partially toward the principal. As you make payments over the years, your principal (or bottom line loan amount) slowly decreases. This process is called amortization.
Negative amortization is when the principal amount of your loan actually increases as you pay your monthly payments. This is because the payment amount, as structured with your negative amortization loan, is so low that it doesn't even cover the full amount of the interest. Therefore, the interest continues to compound and the principal amount is never touched.
While this may not sound like a very good loan program for most buyers, a negative amortization loan is sometimes the best-if not the only-option for homebuyers who have very little to contribute toward a monthly payment. Sometimes it's also a good choice for investors who aren't planning on holding onto the home long enough for the loan value to really boost. That way, they can keep a low overhead with low monthly payments yet still sell the home later for a profit. But it's not a good loan program for everyone, especially those who are planning on living in their home for a long time.
The biggest disadvantage of negative loan amortization comes when the homeowners want to sell their home. If they've lived in it for several years while paying on a negative amortization loan, it's possible that the loan amount has become larger than the amount that they can actually sell the house for. In other words, when they go to sell the house, not only will they not gain any profit, but they'll actually owe money to the bank. So if a homeowner doesn't fully understand the long-term consequences of a negative amortization mortgage, it can lead to severe and unexpected financial difficulty with negative affects on your credit-even foreclosure or bankruptcy.
This serious potential consequence is just one reason why it's crucial for potential homebuyers to understand what negative amortization is and how it can affect their financial future. If you're considering purchasing a home under a negative amortization loan program, be sure to explore all of the pros and cons with your loan officer or mortgage broker.
The other comments are accurate although they leave out an important information. Because the amount owed on the mortgage can increase the lender has a maximum amount they will allow it to grow to. The exact amount varies with each lender. But when it occurs the payment is recalculated to start paying the loan off in the balance of the remaining time of the agreed upon term at the then current rate. This can happen as early as 2 years into the mortgage. The exact time this occurs varies with payment, current indices, margins and terms set by the lender. Be assured though it happens in every negative amortization mortgage. This recasting of the payment as this is called can cause the payment double or triple.
This event often forces the homeowner to sell the home as they can not afford the payment. If they fail to make the payments they may lose the home through foreclosure. Or it forces the homeowner to refinance again but with a much larger mortgage balance. The mortgage company is fully aware of the scenarios and use it to keep you coming back as a customer.
The question of suitability of this mortgage type for many borrowers deserves to be asked. It is good for the lender's repeat business. The verdict is not in if it is good for the consumer.