Our explanation of negative amortization has to start with some accounting terminology.
Amortization happens when you reduce the principal of your loan by paying down the principal balance. This means you’re making a monthly mortgage payment that’s large enough to reduce the principal of the loan as well as paying off interest. However, you will sometimes encounter loans with payments so low that they don’t cover both the interest and principal.
Interest-only loans: There are interest-only loans where your monthly payments only cover the cost of interest; so when you reach the end of the end of the loan term you owe just as much as you borrowed in the first place.
Negative amortization loans: And then there are negative amortization loans—where your monthly payments are less than the cost of interest. This happens when you reach the end of the loan term and you owe more than what you borrowed because unpaid interest has been added back to your principal balance.
You may not be used to considering negative amortization in terms of your mortgage, but it is a common concept with credit cards. For example, negative amortization is what happens when you make minimum payments on your credit card and your debt keeps going up.
Why get a mortgage with a negative amortization? No one likes to see their debt going up, so why get a mortgage with a negative amortization? The biggest reason is lower mortgage payments. Even though you’re increasing your debt over time, low up-front payments can help you get into a home now.
There are several situations in which a negative amortization mortgage may make financial sense, depending upon your situation:
- If you have limited financial means, but you’re going to be making more money in the future, you can get in at a low cost and pay the balance off later.
- If property values in the area are going up, you may find that you can sell your home in the future and still pay off your loan, and even turn a profit.
- Combined with an Adjustable Rate Mortgage (ARM), a period of negative amortization can help you get in with even lower up-front costs; and rising payments later will let you pay down the principal.
- If you don’t plan to stay in the home long, you can get in with low initial payments and get out again before you’ve racked up too much in interest. This can work especially well when combined with rising property values or an Adjustable Rate Mortgage (ARM).
What are the risks of negative amortization? All of these may be a bit of a financial gamble. If property values drop, if you don’t wind up with money to pay down the principal, or if you stay in the home longer than you planned—negative amortization could backfire and land you in a mountain of debt.
Should I be worried about my mortgage? Though the concept of negative amortization may sound scary, you shouldn’t be worried. To protect home buyers from predatory lending practices, government regulated restrictions for negative amortization mortgages have been put into place. One example is that you cannot get into a mortgage without knowing your repayment options. And some states have gone even further and banned negative amortization mortgages all together. Many states have gone even further and banned negative amortization mortgages all together.
Where you’re most likely to encounter negative amortization, besides those minimum credit card payments, is with an ARM. An ARM will often have limits on the amount mortgage payments can increase year to year. If the interest rate has jumped significantly, you may find yourself paying negative amortization for a period of time.
How do I avoid negative amortization? If you would rather avoid negative amortization, you could consider taking out a Qualified Mortgage. A Qualified Mortgage meets specific federal standards that protect home buyers from predatory lending practices like interest-only loans, certain types of negative amortization loans, or balloon payments.
However, that is not your only option. There are plenty of financial institutions that offer mortgage loans that are not qualified in this way. PenFed has a wide-selection of mortgage programs to choose from that are not negative amortization loans.
Know your loans. The takeaway here is that before you sign on the dotted line, be sure that you understand all the terms and conditions of your loan. Make sure you are getting a fair deal; talk over the terms with your lender, and do your research to make sure you know what type of loan you are getting.