When a borrower makes a loan payment and the payment is less than the interest owed, this difference gets added to the loan payment and negative amortization is what occurs.
When you have a loan and make payments to the bank for it, it is split into two parts. One is the interest which is owed for the month and the other is termed amortization. This is the amount you are actually paying towards the loan amount.
To put this example into numbers imagine you have a mortgage for $100,000 with a 6% interest rate for a term of 30 years. If your payments each month are $600, only $100 of the payment goes towards the amortization which leaves you a balance of $99,900 on the principal while the remaining $500 goes to the interest.
A payment of $600 every single month is a fully amortizing payment because it will eventually pay the balance of the loan off, after the term of 30 years. Something that is larger than the initial payment, $700 for example, would pay it off in less time and less than that would make the loan longer than 30 years.
A payment that does not pay the total amount, such as $550, is considered a partial amortization since it does pay towards the principal but in more than 30 years. A payment that is only $500 would not be amortizing at all and would only cover the interest rate. At the end of the loan, you still owe the full principle. This was quite common during the 1920's and people would have to refinance at the end of the loan term to continue paying on the mortgage unless it got sold sometime during the time period.
Some loans currently work on an interest only basis for a short time period and then the principal is tacked on to make the payments fully amortizing so that the original loan commitment is fulfilled. In the previous example, payments may only be $500 for 5 years but for the remaining 25 years the payments will be raised to $644 so that the loan will get paid off in the term of 30 years.
Another situation is if the interest isn't even being met by the payment. If you decided that you're only going to be paying $400 for example you will owe a balance of $100,100 at the end of the month. The bank is continuing to lend you money every month and even though you're making payments the amount you owe increases. This is when negative amortization occurs.
Negative amortization has been used in the past to allow lower payments in the beginning of the loan contract for both fixed rate and adjustable rate mortgages. ARMs may also use this to decrease the amount of the payment owed when the interest rate increases.
Negative amortization has the downfall of requiring payments to be increased sometimes significantly in order to make the loan fully amortized during the loan time period. For a fixed rate loan negative amortization functions solely to reduce payments during the beginning of the loan and are referred to as graduated payment mortgages.
Negative Amortization and Payment Shock on Graduated Payment Adjustable Rate Mortgages
When interest rates are high, like during the 1980's, negative amortization allowed lower payments during the beginning terms of the loan. Payments were set low ahead of time and everyone knew about the negative amortization.
The problems occur if interest rates increase further. This could further increase the negative amortization and then payment shock would occur when the time was up and the people defaulting skyrocketed. A new type of negative amortization called "flexible payment ARM" surfaced in the 90's which allowed the borrower to make a minimum payment not covering the interest, an interest only payment, or a fully amortizing one.
When you have a loan and make payments to the bank for it, it is split into two parts. One is the interest which is owed for the month and the other is termed amortization. This is the amount you are actually paying towards the loan amount.
To put this example into numbers imagine you have a mortgage for $100,000 with a 6% interest rate for a term of 30 years. If your payments each month are $600, only $100 of the payment goes towards the amortization which leaves you a balance of $99,900 on the principal while the remaining $500 goes to the interest.
A payment of $600 every single month is a fully amortizing payment because it will eventually pay the balance of the loan off, after the term of 30 years. Something that is larger than the initial payment, $700 for example, would pay it off in less time and less than that would make the loan longer than 30 years.
A payment that does not pay the total amount, such as $550, is considered a partial amortization since it does pay towards the principal but in more than 30 years. A payment that is only $500 would not be amortizing at all and would only cover the interest rate. At the end of the loan, you still owe the full principle. This was quite common during the 1920's and people would have to refinance at the end of the loan term to continue paying on the mortgage unless it got sold sometime during the time period.
Some loans currently work on an interest only basis for a short time period and then the principal is tacked on to make the payments fully amortizing so that the original loan commitment is fulfilled. In the previous example, payments may only be $500 for 5 years but for the remaining 25 years the payments will be raised to $644 so that the loan will get paid off in the term of 30 years.
Another situation is if the interest isn't even being met by the payment. If you decided that you're only going to be paying $400 for example you will owe a balance of $100,100 at the end of the month. The bank is continuing to lend you money every month and even though you're making payments the amount you owe increases. This is when negative amortization occurs.
Negative amortization has been used in the past to allow lower payments in the beginning of the loan contract for both fixed rate and adjustable rate mortgages. ARMs may also use this to decrease the amount of the payment owed when the interest rate increases.
Negative amortization has the downfall of requiring payments to be increased sometimes significantly in order to make the loan fully amortized during the loan time period. For a fixed rate loan negative amortization functions solely to reduce payments during the beginning of the loan and are referred to as graduated payment mortgages.
Negative Amortization and Payment Shock on Graduated Payment Adjustable Rate Mortgages
When interest rates are high, like during the 1980's, negative amortization allowed lower payments during the beginning terms of the loan. Payments were set low ahead of time and everyone knew about the negative amortization.
The problems occur if interest rates increase further. This could further increase the negative amortization and then payment shock would occur when the time was up and the people defaulting skyrocketed. A new type of negative amortization called "flexible payment ARM" surfaced in the 90's which allowed the borrower to make a minimum payment not covering the interest, an interest only payment, or a fully amortizing one.