Negative Amortization

Definition

Negative amortization is a financial term that refers to the situation where the principal balance of a loan increases because the borrower fails to pay the full interest due. For example, if the interest payment on a loan is $500 and the borrower only pays $400, the $100 difference is added to the principal balance of the loan.

Origin

The concept of negative amortization originated in the field of loan and debt management, particularly in cases of insufficient interest payments. As financial products became more complex, this concept gained wider application in the late 20th century, especially in mortgage and student loans.

Categories and Features

Negative amortization primarily occurs in two types of loans: adjustable-rate loans and certain types of student loans. In adjustable-rate loans, interest rates may fluctuate, causing the borrower's payments to be insufficient to cover the interest due. In student loans, particularly during deferment periods, interest may accumulate and be added to the principal. A key feature of negative amortization is that it increases the borrower's debt burden, potentially leading to higher long-term repayment costs.

Case Studies

A typical case is the subprime mortgage market during the 2008 financial crisis. Many borrowers opted for loans with low initial rates, but as rates increased, they failed to pay enough interest, leading to negative amortization. Another example is student loans, where many students face negative amortization after graduation because the interest accrued during their studies is added to the principal.

Common Issues

Investors often misunderstand the impact of negative amortization, thinking it is merely a temporary accumulation of interest. However, negative amortization increases the principal, thereby increasing future interest payments and total repayment amounts. Borrowers should carefully read loan terms to understand potential negative amortization risks.