Negative Amortization and ARMs

The phenomenon of negative amortization occurs when your monthly payments are not sufficient to cover the amount of interest owed for that month. The unpaid interest for the month is added on to the mortgage’s principal and used in calculating the interest for the next month.

Most mortgages are set up to amortize fully, and your scheduled monthly payment will be enough to cover that month’s interest plus some principal. However, with some mortgage, like certain adjustable rate mortgages (ARMs), the payments do not cover the full amount of interest and negative amortization occurs.

The most common way negative amortization occurs is through an ARM with a payment cap. Rather than placing limits on interest rate increases at each adjustment period, payment caps instead limit the amount your monthly payment can increase.

These limits can be attractive because they ensure that you will not be stuck with monthly payments you can’t afford, no matter what the current rate of your ARM. However, these caps can also result in a situation where your payments aren’t covering the amount of interest owed each month – in short, negative amortization can occur.

While negative amortization isn’t particularly desirable, appreciating real estate values have the potential to offset losses through negative amortization by increasing equity. Most loans also set a cap on negative amortization, limiting the amount your loan principal can increase. It is important to note that these caps can also have negative effects, which will be explored more fully in another section.

Overall, an ARM that features payment caps will always also contain the possibility of negative amortization. For some, the guarantee of lower monthly payments is worth the risk of increasing their total loan amount through negative amortization.

For others, an ARM with a periodic interest cap is preferable, since it also limits payment increases to an extent while assuring the loan will amortize fully at the end of its term. The decision can only be made by each individual borrower.