Negative amortization loans are better understood when the term amortization is defined. This is the reduction in the balance of a loan, usually by paying any interest accrued for a month and an additional amount that reduces the loan total. With negative amortization, payments don’t even cover the interest, which adds to the balance of the loan. Borrowers end up owing more each month or loan period, and new amounts are subject to interest charges.
Up until the early 2000s, negative amortization loans were often viewed with favor. This feature was previously common in many home mortgage loans, and was one way to secure a home loan if borrowers couldn’t make initially high mortgage payments. Other types of negative amortization loans exist, and especially some private or unsubsidized government student loans still work in this way.
One of the types of negative amortization loans that enjoyed great popularity was the adjustable rate mortgage (A.R.M.s). In part, A.R.M.s contributed to the housing market and bank crisis of the 2000s. Borrowers who wouldn’t ordinarily qualify for high payment loans, started with payments insufficient to cover interest. Over time, payment amounts on these loans rose and borrowers faced much higher payments on larger loans than the ones they’d initially made. In many cases, people couldn’t afford higher payments, and combined with a significant fall in housing values, many were forced to walk out on loans they could no longer afford.
This example illustrates the potential pitfalls of negative amortization loans. The loan gets bigger for every period that a payment is due, which means eventually, rates of repayment must go up significantly. Sometimes these increases are minor and only the first few payments negatively amortize the loan. It’s now less common for lenders to offer these, especially to borrowers who can’t afford the cost of the loan when payments do increase.
Other lending options that might be considered include the interest only loan, where there is no negative amortization but also no amortization. Essentially the balance stays at the initial amount borrowed, but eventually payments increase so that more than interest is paid. Alternately, some lenders have repayment strategies where borrowers pay anywhere from less than full interest, to above full interest to amortize the loan. Most financial experts recommend people with flexible repayment strategies do their utmost to make payments that include all interest and that reduce loan size.
Some types of student loans have the possibility of being negative amortization loans. Certain loans accrue interest while students are in school, but make interest repayment optional until studies are completed. From a financial perspective, students should consider whether forgoing interest payments is wise. The amount of interest that can accrue on large loans over the course of four or five years can significantly raise loan payments, because the size of the loan increases each month. Simple loan calculators can inform student borrowers approximately how much more money they’ll end up owing by skipping interest payments.