Negative Amortization
A traditional mortgage loan payment is ususlly applied partially to interest and partially to principal. Amortization is the paying off of the principal in regular installments over a period of time. On the other hand, negative amortization is when the borrower pays back less than the full amount of interest owed to the lender each month. Thus, the difference between what should have been paid and what was actually paid is added to the principal amount owed to the lender, resulting in the accumulation of more debt as opposed to equity.
Negative amortization loans typically have adjustable rates. In other words, they are fixed for a specified period and adjust when that period has elapsed. The Graduated Payment Mortgage is a fixed-rate Negative Amortization loan, payments for which increase over time.
Negative amortization increases on loans features where the minimum installment does not cover the amount of interest due on a loan, the interest rate adjusts more frequently than the monthly payment, or where the changes in the monthly payment are capped. As a consequence, the principal balance rises.
Most lenders only allow Negative Amortization to happen for a specified period, which is typically five years. Lenders can also pre-determine an amount, which if reached through negative amortization would trigger the loan to enter a fully amortizing or regular payment schedule. The specified period or amount protects the lender, not the borrower, in that it allows the lender to change the loan to fully amortizing.
Predatory lenders use Negative Amortization features to lure borrowers into buying more than what they can afford, because negative amortization increases affordability by adding payment savings and payment flexibility to a mortgage loan.
According to the Mortgage Professor, if interest rates rise persistently, home equity will decline rather than rise unless the negative amortization is offset by house appreciation. In addition, negative amortization must be repaid, which means the payments are going to rise in the future. The larger the negative amortization, the greater will be the increase in the future payments that will be required to amortize the loan in full.