Negative Amortization: What You Need to Know

Negative amortization refers to the process through which a loan's outstanding balance increases over time, despite payments being made on the loan. That's because borrowers are allowed to make lower payments than what's necessary to decrease the loan's balance. As a result, these lower payments go towards paying some of the interest accruing on the loan, and the remainder of the unpaid interest is added to the balance. After the initial period of reduced interest payments, regular payments are made to pay down the loan.

Negative Amortization Explained

To understand negative amortization, it's important to have a baseline knowledge of how regular amortization works. On installment loans that amortize normally, like a typical auto loan or 30 year mortgage, the loan's balance is gradually paid off through fixed monthly payments. These payments, known as fully amortized payments, are comprised of both interest and principal. As the loan balance decreases, more of each monthly payment goes towards principal and less goes towards interest.

On a loan with negative amortization, fully amortized payments are not initially made. Instead, partial interest payments are made at each period, and the rest of the interest is deferred. In a process called interest capitalization, the deferred interest is then added to the loan's outstanding balance—increasing the total amount owed. Due to the deferment of full payment, the monthly payment increases substantially once the full payment period begins.

Negatively Amortizing LoansFully Amortizing Loans
  • Loan balance increases before it decreases
  • Low initial payments; higher payments after
  • Initial payments comprised of only interest
  • Loan balance continuously decreases
  • Fixed payments throughout life of loan
  • All payments comprised of interest and principal

While negative amortization does indeed allow for lower initial costs, the eventual spike in monthly payments makes them more financially risky than loans on fully amortizing schedule. In general, lenders no longer provide loans that negatively amortize. After widespread loan default in the late 2010s, loans with more complicated payment schedules are no longer readily available. Historically, borrowers who took on loans with this type of graduated payment schedule left themselves unprepared for the increased payment.

Student Loans

Student loans are one of the last remaining consumer debt products that have negative amortization. This is because payments on most student loans don't have to be made until the borrower is out of school, and interest accrues before the payment period begins. Through the process of interest capitalization, as mentioned above, the accrued interest is added to the loan balance when the repayment period starts—and any future interest is calculated using the new balance.

If you're currently in school and have Federal Unsubsidized Loans or private loans, interest is currently being added to your outstanding debt. One way to cut down on the total cost of your student loan and eliminate interest capitalization is to pay off interest while you're still in school. Most student loan programs allow borrowers to repay some or all of their debt before the mandatory repayment period begins.

Credit Cards

While credit card payment schedules are structured differently from installment loans, a good example of negative amortization is an unpaid credit card balance. Consider the consumer who has $2,500 in credit card debt and an annual interest rate of 20%. Even if they don't add to their balance by spending, low monthly payments could, in theory, make the balance increase as interest costs are applied.

MonthAmount PaidBalanceInterest Added at 20% APR
1$40.00$2,500.00$41.67
2$40.00$2,501.67$41.69
3$40.00$2,503.36$41.72
4$40.00$2,505.08$41.75
5$40.00$2,506.84$41.78
6$40.00$2,508.62$41.81
7$40.00$2,510.43$41.84
8$40.00$2,512.27$41.87
9$40.00$2,514.14$41.90
10$40.00$2,516.04$41.93
11$40.00$2,517.97$41.97
12$40.00$2,519.94$42.00

However, credit card issuers are typically required to set minimum monthly payments that negate the possibility of negative amortization. As shown above and below, the difference of $10 in a monthly payment can mean the difference between negative amortization and decreasing a debt.

MonthAmount PaidBalanceInterest Added at 20% APR
1$50.00$2,500.00$41.67
2$50.00$2,491.67$41.53
3$50.00$2,483.19$41.39
4$50.00$2,474.58$41.24
5$50.00$2,465.82$41.10
6$50.00$2,456.92$40.95
7$50.00$2,447.87$40.80
8$50.00$2,438.67$40.64
9$50.00$2,429.31$40.49
10$50.00$2,419.80$40.33
11$50.00$2,410.13$40.17
12$50.00$2,400.30$40.00

Mortgages

As lending regulations have tightened in recent years, mortgages and car loans with pure negative amortization schedules have become effectively non-existent. However, some mortgage lenders are starting to issue a similar product called an interest-only mortgage. This type of mortgage allows borrowers to make only interest payments for a certain number of years, usually 10, and then make fully amortized payments with principal and interest for the remainder of the loan's term.

Like negative amortization mortgages, interest-only loans have a lower monthly payment that will spike after the initial period. These mortgages are complex financial products and are generally only used by those who need a special financing option for a large loan. For the average homebuyer, a fully amortizing mortgage is a much safer option.

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