History and Purposes of Negative Amortization

Negative amortization is a part of certain mortgages that concern many borrowers who are considering these loans. Consumers may not fully understand negative amortization, or what the purposes stand behind this type of amortization. This section takes a look at the history and purposes of negative amortization in a variety of settings.

Historically, negative amortization has been used primarily to lower the size of a loan’s initial monthly payments. By setting up a loan that allows the borrower to pay less than the total interest due for the month, monthly payments are lowered substantially. This is an attractive feature to many borrowers, who need low monthly payments to qualify for a loan covering the home they wish to purchase.

Other borrowers simply want to save money in order to invest the savings in other areas and hopefully gain a higher return. This purpose for negative amortization applies equally to adjustable rate mortgages (ARMs) and fixed rate mortgages, though negative amortization is historically more strongly associated with ARMs.

A second purpose for negative amortization, and one that arose more recently, is to reduce the potential for payment shock. This is applicable only with ARMs, where the possibility for payment shock exists because of the potential for interest rates to increase substantially at the adjustment period. Payment caps that limit the amount monthly payments can increase may limit payments to amounts lower than the amount of interest owed and result in negative amortization.

While negative amortization may help alleviate payment shock in the short term, if the negative amortization limit is reached, payment shock may be even worse. In this case, the payments are recalculated to be fully amortizing without regard to any cap, often at a much higher level than payments were previously made.

Negative amortization can be useful for the purposes listed above, but it is important to always remember that it will always increase your payments in the long run, whatever loan type you choose.