What is negative amortization? Definition and examples
If the interest on your loan is higher then your repayments, then you could find yourself paying a debt which continues to grow.
Negative amortization is a term in finance used to describe when the initial balance of a loan increases over time rather than decreasing as it normally would with standard loan amortization.
It occurs when the borrower’s payments are insufficient to cover the interest accruing on the loan, resulting in unpaid interest being added to the loan’s principal balance. This can lead to a growing debt instead of a decreasing one despite payments being made
Negative amortization is most commonly found in adjustable-rate mortgages (ARMs) and some types of student loans. In these loans, there is a specified period during which the borrower makes minimum payments that do not cover the full amount of interest due. The unpaid interest is then added to the loan’s principal balance, causing the overall debt to increase over time.
Examples of negative amortization
Adjustable-Rate Mortgages (ARMs)
Let’s say you have an ARM with a low introductory interest rate for the first five years. During this period, you make minimum monthly payments based on that low rate. However, the actual interest rate may be higher, and the difference between the minimum payment and the interest owed is added to the principal balance.
After the introductory period, the loan’s interest rate adjusts to market rates, and your payments would increase significantly to cover both the interest and principal. This can result in “payment shock” for borrowers.
Some student loans offer income-driven repayment plans where your monthly payments are based on your income. This includes the new SAVE plan that has been touted by the Biden administration in the gap left by next to no promised student debt forgiveness.
If your income is low, your monthly payment may not cover the accruing interest. In this case, the unpaid interest may be added to the loan’s principal. While these plans can be helpful for borrowers with lower incomes, they can lead to negative amortization and a growing loan balance overtime. This is how student payments are managed in the UK leaving hundreds of thousands of students with a growing debt.