What is a Negative Amortization Loan?
A negative amortization loan is a type of loan that doesn’t reduce your balance. In other words, you're not paying back any principal. In fact, with a negative amortization loan your loan balance increases over time.
How Does a Negative Amortization Loan Work?
Your loan payment is figured by using the loan amount, the interest rate, and the number of years to pay back the loan. For a traditional mortgage, you pay enough each month to cover some interest and some principal. With a negative amortization loan, you don't even pay enough to cover all the interest (so forget about paying down any of the balance).
So What Does "Negative Amortization" Mean?
Because your payments with a negative amortization loan are not even enough to cover the interest costs, the interest you didn’t pay is added to the loan balance. One way of looking at this is that each time you make a payment, you owe the bank more.
Amortization means to reduce something (like your loan balance) over time. A negative amortization loan actually increases your loan over time, so you “un-amortize” the loan.
Why Would Anybody Use a Negative Amortization Loan?
The main reason negative amortization loans exist is to lower monthly payments.
Some folks use loans with negative amortization to get into a house they otherwise can’t afford. Usually they believe that they’ll have more income in the future. While you do enjoy lower payments today, the cost of a negative amortization loan is that you have to pay more later. Sometimes this can make sense. However, use the strategy at your own risk.
Speculators may use negative amortization loans when they believe home prices will increase rapidly. Again, it’s just a strategy to keep monthly payments low. While this may work wonderfully in theory, you should know that speculating on real estate is risky – and using a negative amortization loan adds risk and leverage.