Key Takeaways
- Negative amortization occurs when unpaid interest is added to the principal of a loan, causing it to increase over time.
- It is most commonly associated with adjustable-rate mortgages (ARMs) and other flexible payment mortgages.
- While offering short-term payment relief, negative amortization can lead to increased long-term financial burdens and exposure to interest rate fluctuations.
Understanding Negative Amortization
In the realm of loans, negative amortization is like a financial boomerang: what you skip paying now, you’ll pay later, but with a little extra. This phenomenon occurs in certain mortgage products allowing borrowers to choose smaller payments that don’t cover the full interest due. The unpaid interest then gets added to the loan’s principal, setting the stage for a larger debt down the line.
This concept might sound appealing at first—like ordering a burger but saying you’ll pay for the fries next month. But just like your waistline might suffer from too many delayed fries, your loan balance suffers from deferred interest.
Graduated Payment Mortgages (GPMs) are a notable example where payments start small and increase over time. Initially, these payments might cover less than the accruing interest, leading to negative amortization. Over time, as payments increase, they start to cover and surpass the interest expenses, reducing the principal more significantly.
The allure of negative amortization is primarily its ability to lower initial loan payments, making it seem more manageable in the short term. However, it’s akin to sipping a cocktail with a financial twist of lemon: initially refreshing with a sharp kick later on if interest rates rise.
Real-World Example of Negative Amortization
Consider a fictitious borrower, Mike, who takes out an adjustable-rate mortgage. At onset, rates are low, allowing for smaller monthly payments. Mike opts to pay minimal interest, which initially keeps his payments low but causes his loan principal to inflate over time.
Imagine interest rates climb. Now, Mike faces a double whammy: his monthly payments jump, and he owes more on the loan principal. His initial financial relief is quickly overshadowed by mounting repayment obligations—the classic case of more month at the end of the money.
Related Terms
- Adjustable-Rate Mortgage (ARM): A mortgage with an interest rate that changes periodically based on the performance of a specific benchmark.
- Graduated Payment Mortgage (GPM): A type of mortgage where payments start low and increase over time.
- Interest Rate Risk: The risk that an investment’s value will change due to a change in the absolute level of interest rates.
Suggested Reading
- “The Mortgage Encyclopedia” by Jack Guttentag
- “Personal Finance For Dummies” by Eric Tyson
Both books provide further insights into mortgage types and personal financial strategies to handle the complexities of negative amortization efficiently.
In this Shakespearean financial drama of negative amortization, the cautionary tale is straightforward: “To defer, or not to defer,” that is the question. The answer? Defer wisely, and sparingly.
