Negative Amortization occurs when the payments made on a loan are not sufficient to cover the interest charges, causing the loan’s principal balance to increase over time. This situation is more common with adjustable-rate or indexed loans where the interest rate can fluctuate without changing the monthly payment amount.
Examples
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Adjustable-Rate Mortgages (ARMs): A borrower with an ARM might see their monthly payments remain the same while the interest rate increases due to market conditions. If the payment does not cover the new interest charges, the unpaid interest is added to the loan principal, resulting in negative amortization.
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Graduated Payment Mortgages: These types of loans have lower initial payments that gradually increase over time. During the initial period, the payments might not fully cover interest costs, leading to negative amortization until the payment amount catches up.
Frequently Asked Questions
Q1: What is negative amortization in simple terms?
- Negative amortization means the loan balance increases because the payments do not cover the interest due.
Q2: How does negative amortization affect borrowers?
- Borrowers may end up owing more than the original loan amount, which can make the loan more expensive and extend the repayment period.
Q3: Is negative amortization illegal?
- No, but it is risky. It is sometimes used in certain types of loans, usually under specific terms agreed upon by the lender and borrower.
Q4: Can negative amortization lead to default?
- Yes, if the principal balance increases significantly and the borrower is unable to meet higher payment demands, it could lead to default.
Indexed Loans: Loans with interest rates tied to a financial index, causing the rate and payment amount to adjust periodically.
Interest Rate: The percentage charged by a lender to a borrower for the use of assets.
Debt Service: The cash required over a given time to cover the repayment of interest and principal on a debt.
Adjustable-Rate Mortgage (ARM): A mortgage with an interest rate that varies according to a specific benchmark, causing potential changes in the monthly payment amount.
Graduated Payment Mortgage: A type of fixed-rate mortgage with initial low payments that gradually increase over time.
Online Resources
References
- Brueggeman, William B., and Fisher, Jeffrey D. Real Estate Finance and Investments. McGraw-Hill Education.
- Geltner, David M., et al. Commercial Real Estate Analysis & Investments. OnCourse Learning.
Suggested Books for Further Study
- Galaty, Fillmore W., et al. Modern Real Estate Practice. Kaplan Publishing.
- Ling, David C., and Archer, Wayne R. Real Estate Principles: A Value Approach. McGraw-Hill Education.
- Brown, Gary L. Real Estate Loan Origination and Construction Lending. American Bankers Association.
Real Estate Basics: Negative Amortization Fundamentals Quiz
### What is negative amortization?
- [ ] When the loan balance decreases due to excess payments.
- [x] When the loan balance increases due to insufficient payments covering interest.
- [ ] When the property value depreciates.
- [ ] When the loan interest rate is fixed.
> **Explanation:** Negative amortization occurs when the payment made is insufficient to cover the interest due, causing the unpaid interest to add to the principal balance.
### What type of loan is most susceptible to negative amortization?
- [ ] Fixed-rate mortgage
- [ ] Balloon payment loans
- [x] Adjustable-rate mortgage (ARM)
- [ ] Interest-only mortgage
> **Explanation:** Adjustable-rate mortgages (ARMs) are most susceptible to negative amortization as the interest rate can fluctuate, potentially increasing without a corresponding increase in the monthly payment amount.
### How can negative amortization impact the life of the loan?
- [ ] Decreases the total payment period
- [x] Increases the total payment period
- [ ] Has no effect
- [ ] Reduces interest rates over time
> **Explanation:** Negative amortization increases the outstanding loan balance, making it take longer to repay and extending the total payment period.
### Negative amortization often occurs in loans that are...
- [ ] Fixed-rate
- [ ] Fully amortizing every month
- [x] Allowing minimum payments that do not cover interest
- [ ] Daily compounding
> **Explanation:** Loans that allow minimum payments insufficient to cover the interest, such as some adjustable-rate loans, can result in negative amortization.
### What is a significant risk associated with negative amortization?
- [x] Loan balance exceeding property value
- [ ] Paying less interest over time
- [ ] Fixed monthly payments
- [ ] Decreased lender profit
> **Explanation:** A significant risk of negative amortization is that the loan balance can grow large enough to exceed the property's value, leading to potential negative equity.
### Which of the following helps to prevent negative amortization?
- [x] Making payments that cover all interest due
- [ ] Making minimum allowed payments
- [ ] Avoiding principal payments
- [ ] Choosing adjustable-rate loans
> **Explanation:** Making sure that payments cover all interest due prevents negative amortization from occurring, as it avoids adding unpaid interest to the loan balance.
### In what situation can negative amortization be beneficial?
- [ ] When aiming to build equity quickly
- [ ] When intending to keep the loan long-term
- [x] Temporarily reduce monthly payments for short-term financial relief
- [ ] Increase monthly principal now
> **Explanation:** Negative amortization can temporarily reduce monthly payments providing short-term financial relief, though it increases the overall cost of the loan.
### What is a “payment cap” in relation to negative amortization loans?
- [ ] A maximum limit on the loan balance
- [ ] A cap on interest rate changes
- [x] A limit on how much the payment can increase, potentially causing negative amortization
- [ ] An upper limit on the loan term
> **Explanation:** A payment cap limits how much the payment can increase, but can lead to negative amortization if the capped payment is insufficient to cover rising interest costs.
### Who regulates loan practices including the explanation of negative amortization?
- [ ] Federal Aviation Administration
- [x] Consumer Financial Protection Bureau (CFPB)
- [ ] National Weather Service
- [ ] Department of Agriculture
> **Explanation:** The Consumer Financial Protection Bureau (CFPB) regulates loan practices and ensures that lenders explain the implications of negative amortization to borrowers.
### How often are interest rates typically adjusted on an adjustable-rate mortgage (ARM)?
- [ ] Monthly
- [ ] Weekly
- [ ] Semi-annually
- [x] Annually
> **Explanation:** Adjustable-rate mortgages (ARMs) typically adjust their interest rates annually, though the specifics can vary based on the loan agreement terms.
