Negative Amortization Caps

Negative amortization is a process that allows your loan’s balance to increase rather than decreasing over the loan’s life. It occurs when your monthly payments are less than the interest owed, and the difference is added back to the total balance of your loan.

At first glance, this looks like a terrible idea. Most loans are set up to gradually reduce the balance, or principal, over time, culminating in the total repayment of the principal at the end of the loan’s term. Negative amortization seemingly upsets this plan by increasing rather than decreasing the loan balance each month.

However, lenders will not allow this to continue throughout the loan’s entire life. Mortgages that have payment caps that can result in negative amortization also have limits on the amount of negative amortization allowed.

These negative amortization caps are expressed as a percentage of the original loan amount. Caps commonly range from 110 to 125 percent of the loan’s original balance. For example, a $200,000 loan with a 115 percent cap would allow negative amortization until the new balance reached $230,000.

At this point, negative amortization is stopped through an automatic payment recast. Payment recasts work by reconfiguring your monthly payments to be fully amortizing, based on the current loan amount, the current interest rate, and the amount of time left on the loan’s term. Recasts are done without consideration of any payment caps, and have the potential to raise monthly payments dramatically.

For this reason, mortgage amortization caps can be both a positive and a negative. They prevent your loan’s balance from reaching a level that is higher than you can deal with. On the negative side, however, if these caps are reached, they have the potential to raise your monthly payments dramatically.