September 15, 1998, Revised July 9, 2007
Negative amortization arises when the payment made by the borrower is
less than the accrued interest and the difference is added to the loan
balance.
Negative Amortization and Related Concepts
Ordinarily, the mortgage payment you make to the lender has two parts:
interest due the lender for the month, and amortization of principal.
Amortization means reduction in the loan balance -- the amount you still
owe the lender.
For example, the monthly mortgage payment on a level payment 30-year
fixed-rate loan of $100,000 at 6% is $600. (For convenience, I am
leaving out the pennies). In the first month, the interest due the
lender is $500, which leaves $100 for amortization. The balance at the
end of month one would be $99,900.
Because a payment of $600 a month maintained over 30 years would just
pay off the balance, assuming no change in the interest rate, it is said
to be the fully amortizing payment. A payment less than $600 would leave
a balance at the end of 30 years. A payment greater than $600 would pay
off the loan before 30 years.
Suppose you made a payment of $550, for example. Then only $50 would be
available to reduce the balance. Amortization would still occur, but it
would be smaller and not sufficient to reduce the balance to zero over
the term of the loan. $550 is a partially amortizing payment.
Next, suppose you pay only $500. Since this just covers the interest,
there would be no amortization, and the balance would remain at
$100,000. The monthly payment is interest-only. Back in the 1920s,
interest-only loans usually ran for the term of the loan, so that the
borrower owed as much at the end of the term as at the beginning. Unless
the house was sold during the period, the borrower would have to
refinance the loan at term.
Today, some loans are interest-only for a period of years at the
beginning, but then the payment is raised to the fully-amortizing level.
For example, if the loan referred to above was interest-only for the
first 5 years, at the end of that period the payment would be raised to
$644. This is the fully-amortizing payment when there are only 25 years
left to go. See
Interest Only
Mortgages.
Finally, suppose that for some reason, your mortgage payment in the
first month was only $400. Then there would be a shortfall in the
interest payment, which would be added to the loan balance. At the end
of month one you would owe $100,100. In effect, the lender has made an
additional loan of $100, which is added to the amount you already owe.
When the payment does not cover the interest, the resulting increase in
the loan balance is negative amortization.
Purposes of Negative Amortization
Historically, the major purpose of negative amortization has been to
reduce the mortgage payment at the beginning of the loan contract. It
has been used for this purpose on both fixed-rate mortgages (FRMs) and
adjustable rate mortgages (ARMs). A second purpose, applicable only to
ARMs, has been to reduce the potential for payment shock -- a very large
increase in the mortgage payment associated with an increase in the ARM
interest rate.
The downside of negative amortization is that the payment must be
increased later in the life of the mortgage. The larger the amount of
negative amortization and the longer the period over which it occurs,
the larger the increase in the payment that will be needed later on to
fully amortize the loan.
Negative Amortization on Fixed-Rate Loans
On fixed-rate loans, negative amortization is a tool for reducing the
mortgage payment in the early years of a loan, at the cost of raising
the payment later on. Instruments that incorporate this feature are
called graduated payment mortgages or GPMs. See
What Is a Graduated Payment Mortgage?
Negative Amortization and Payment Shock on Graduated Payment Adjustable
Rate Mortgages
In the high-interest rate environment of the early 80s, negative
amortization on some adjustable rate mortgages (ARMs) served the same
purpose as on GPMs – allowing reduced payments in the early years of the
loan. Payments in the early years of these "GPARMs" were deliberately
set lower than the interest due the lender, resulting in negative
amortization. As with GPMs, the amount of this negative amortization was
known in advance.
If interest rates on GPARMs rose from their initial levels, however, it
could result in additional negative amortization that was not known in
advance. This in turn could result in payment shock. These instruments
experienced default rates even higher than those on GPMs, and they soon
stopped being offered in the marketplace.
In the late 90s, a new type of negative amortization ARM arose called an
"option ARM" or "flexible payment ARM" because the borrower had a choice
of making a fully-amortizing payment, an interest-only payment, or a
"minimum" payment that did not cover the interest. I wrote a number of
pieces about these mortgages in 2005 and 2006. See
Option ARMs.