Negative amortization happens when the payments on a loan are not large enough to cover the interest cost. The result is a growing credit balance that at some point will require larger payments in the future.
Negative payback is possible with any type of loan and it is often seen with student loans and real estate loans.
How does negative payback work?
To understand negative payback, it is best to start with simple old payback. Depreciation is the process of paying down a loan balance (often monthly payments) with fixed payments. For example, if you buy a home with a 30-year fixed-rate mortgage, you will make the same payment every month – even if your loan balance and interest costs decrease over time.
The monthly payments are calculated based on several factors:
- The loan balance – how much you borrow
- The length of time you will be repaying the loan (also known as the term)
- The interest rate charged on your loan balance
A calculation is made with a fixed remuneration that your loans will pay off in full at the end of the period (usually 15 to 30 years for a loan). Every payment has two components:
- Part of the payment covers interest on your debts
- The rest of the payment pays off your debts (or reduces your credit balance)
To learn more and see sample repayment plans, at the bottom of this page, you will find a sample negative amortization chart.
When things go negative?
With some loans, you have the option to pay less than the fully amortizing payment. The main reason to pay less is, of course, it is easier to pay less.
If you pay less than the interest in a given month (or whatever period applies), the interest cost will be added to your loan balance. In other words, you owe more each month. You haven’t really received any money from your lender, but your loan balance is growing because you are not paying interest.
The process of interest in a loan balance of addition known as capital, the interest.
At some point you will have to pay off the loan. This can be done in several ways:
- Through regular amortizing payments (which will be higher than if the loan hadn’t grown)
- By refinancing the loan
- By paying a balloon paying off the debt
Why Use Negative Amortization?
You have to pay either way, so why choose people to let loans grow?
Insolvency: Sometimes you simply don’t have the funds available to make payments. For example, in times of unemployment, you might not be able to pay your student loan. It is possible to apply for the deferment, which can temporarily stop the payments. However, interest is still loaded and you will have to pay the interest if you have subsidized loans. Note that you often have the option of paying the interest (while skipping the larger payment) if you want to avoid negative amortization.
Investor Loans: In some cases, investors are not interested in having to make large monthly payments. This applies particularly to short-term projects (for example a fix-and-flip). This is a speculative and risky way to invest, but some people and companies do it successfully. For the strategy to pay off, you have to sell the investment with enough profit to never pay off the interest.
“Stretching” to buy: Some homebuyers use negative amortization to buy a property that is currently out of their price range. The assumption is that they will have more income later and they would rather buy a more expensive property today than buy a cheaper one and postpone it sometime in the future. This is also a risky strategy – you cannot predict the future, and there are countless stories of expectations that never came true. Some examples of risky loans include option-ARM loans or pick-your-payment loans (which are not as popular as they are used).
Example of negative amortization
To see negative amortization in action, take out a loan and assume that you will pay less than the interest. The scale increases over time.
For example, suppose you have been repaid $ 100,000 monthly at 6% loan for 30 years. In this case we will not pay anything every month and you will see that the loan balance increases. You can build your own repayment plans and use any payment you choose.
As you can see, the amount of interest you pay increases each month – along with your credit balance.