Understanding How Negative Amortization Works in Mortgages

Absent a uniform definition, nonqualified mortgages are what lenders packaged them to be. There’s Angel Oak with its more than $1 billion in non-QM originations projected this year and Lima One that makes loans to experienced property flippers. Their loans may or may not have a feature called negative amortization, which can be a loan product in itself.

What is negative amortization? How does it work in the context of mortgages? Is it all-risk, no-gain feature or product? Let’s understand what happens in a negatively amortizing loan.

What Is Negative Amortization

In its guidelines about Qualified Mortgages (QM), the Consumer Financial Protection Bureau enumerated certain risky features that should be excluded from QM loans. Negative amortization is one, together with interest-only period and balloon payments.

Negative amortization occurs when you make a monthly payment that is less than the interest owed and this deficiency is added to the outstanding balance of the loan.

In the ordinary course of things, the monthly loan payment goes to the interest and the principal of the mortgage. This is called amortization and is meant to reduce the balance of the loan as the mortgage term runs its course and gets paid off.

Minimum Payments, Balloon Payments

There are loans, however, that only require minimum payments. This minimum payment can be interest-free and only covers the principal. The unpaid interest is then added to the unpaid principal, thus increasing the outstanding amount owed to the lender.

This mechanism is somewhat true with interest-only loans if only that minimum payments cover the interest portion of the mortgage during a certain period. During this period, the principal remains unchanged.

At the end of the interest-only period, e.g. 10 years, the loan will have to amortize over the remaining term. This is where larger-than-usual payments come in or balloon payments, prompting homeowners to refinance the loan.

Balloon loans are structured that way, only that after the lower-than-usual monthly payments, a one-time, larger-than-usual monthly payment is required to pay off the loan.

Any Benefits of Negative Amortization?

In fairness, negative amortization keeps the costs of mortgages lower at the onset of the loan. This enables people with irregular income or those expecting a raise to afford a mortgage because of the lower payments. Savings on mortgage payments can be set aside for investments and living expenses.

The situation however becomes difficult when the period requiring minimum payments or interest-only payments is over. The borrower may not afford to make higher payments to amortize the loan or the one-time big-time payment for that matter, and the number of years left to make such payments aggravates the situation.

There is also the danger of having little or no equity to refinance which prevents homeowners from lowering their rate or reducing their payment when the loan reverts to a fully amortizing one.

As with any financial product, it’s best to understand how the loan works before signing up.

Negative amortization loans, interest-only loans and even balloon loans have their own perks especially if we are talking about savings early on in the loan. But you should also consider and have options ready when payments on such loans increase.