Negative amortization describes the situation in which the principal balance on a loan increases with each scheduled repayment against it.
This basically means that more money is owed to the lender after a payment is made.
This financial phenomena is be difficult to accept for a lot of people as common sense would tell us that repayments made against a debt would reduce the outstanding balance by logic.
This is why negative amortization usually only occur in very unique situations where various factors align.
What causes negative amortization
In a nutshell, negative amortization occurs because the scheduled monthly payment for a loan is not enough to pay for the interest due.
This excess in interest becomes deferred interest and gets accrued onto the loan balance.
This happens most often with mortgages that are on floating rate loans with interest rates that adjust according to economic performance and the movement index rates.
For example, a 30 year home loan for $1m might have a scheduled monthly payment of $4,000. But due to fluctuating index rates such as SIBOR, higher interest rates might mean that the increased interest charges put the amount due as $4,500 instead. Because the loan arrangement only contractually requires the borrower to make payment of $4,000, the excess $500 would be added to the principal balance, causing it to rise.
But the fact is that a portion of that $4,000 payment would already go towards reducing the loan principal.
This means that for negative amortization to take place, then the payment towards the principal has to be lower than $500 (as in the above example) for the principal to increase.
The implication of this is that interest has to take up a significant portion of the payment for deferred interest to be higher than payment towards the principal.
However, if a borrower is to refer to the amortization schedule that was initially presented to him when he first applied for, and accepted the home loan, the principal balance would still be higher than what is stated in the amortization table.
Thus, negative amortization has occurred.
For example, a borrower might find that the loan balance would be $500,000 at the end of the 120th month of a mortgage. If negative amortization has occurred on that month, then the actual balance would be more than $500,000 as indicated in the amortization schedule.
This is one way to look at it.
Another way to look at it is that a principal balance is supposed to go from $500,000 to $497,500 in a particular period. But because of a sudden jump in interest rates, the balance only reduced from $500,000 to $499,000. This is because the payment portion going towards principal reduction is still larger than the deferred interest.
In this case, even though the principal has reduced, it can also be categorized as negative amortization.
The consequence of all these is that after the final payment as required by the amortization schedule, there would still be a balance remaining on the account.
The lender would then calculate the final amount due and request for a final discharge payment in order for the borrower to be released from the debt liability.
A refusal to pay this can result in interest rates or penalty charges on the account.
