What is Negative Amortization?
Unless you’re independently wealthy, when you’re ready to purchase a home you’ll seek a mortgage. The terms of a traditional mortgage or home loan require borrowers to make regular monthly payments. These payments cover part of the principal of the loan and some of the interest that accrues on the loan.
Mortgages, Equity, and Amortization Explained
In most cases, the first few years of payments on a home loan are mainly paying interest, with a small portion going toward the principal.
For example, if you have a 20-year fixed-rate mortgage for $100,000 with a 4% interest rate, your payment for the first month would be $605.98, with $333.33 applied to interest and the balance toward the principal. Six months in, it is a $328.76 to $277.22 interest/principal split. As of payment 33, the split evens out and the mortgage payments start to apply more toward the principal. This is when you start to really build up equity, also known as “cash value,” in your home. By the last few years of the loan, almost the entire payment is applied to the principal.
The process of a loan payment being split between interest and principal is called amortization. The breakdown of how much of a payment is applied to the interest and the principal is called an amortization table, and lenders are required to provide one to borrowers when they initially take out the mortgage. The table also includes the gradual decrease of the mortgage for the term of the loan.
How Does Negative Amortization Happen?
With a traditional mortgage, amortization occurs as explained above—the bulk of the payment is applied to the interest on the loan, with the remainder going toward the principal. But if the loan is not a traditional mortgage, then this split doesn’t always happen this way. There are several types of mortgages beyond the traditional 20- or 30-year variety with a locked-in mortgage payment. Some examples of these loans include:
ARMs have interest rates that adjust over a period of time depending on market conditions. One type of ARM, called the minimum-payment option, allows you to make the choice to pay a low minimum payment for a period of time.
Balloon mortgage loans offer smaller payments for the first few years of the mortgage (usually between five and seven years), then a large payment is required, often the balance that remains.
This loan payment starts off small and gradually increases over time. While GPMs were once offered more widely, today they are offered only by the Federal Housing Administration.
All three of these mortgage options have their pros and cons. One major pro, and the reason borrowers are initially attracted to them, is the lower payment at the start of the loan. For those who anticipate their income increasing over the next few years, having a lower mortgage payment now means they can purchase a house sooner. For others, it’s a way to buy a more expensive house now than they would be able to afford with a traditional mortgage.
Another reason the loans are so attractive is that the down payment requirement is lower than with a traditional mortgage. For a regular housing loan, a down payment of 5 to 10% of the home cost is often required to qualify. With specialty loans such as payment-option ARMs and GPMs, the down payment requirement can be drastically lower.
But these pros also lead to the cons of this type of mortgage. The smaller mortgage payments offered by payment-option ARMs, GPMs, and balloon mortgages often mean that not all of the interest is paid on the mortgage.
As part of the mortgage agreement, borrowers get lower payments, but in return, they agree that any interest that is not covered by the mortgage payment is applied to the principal of the loan. For instance, if your mortgage payment is $500, but the interest owed on the loan is $650, the $150 balance is added to the principal of the loan. The increase of the principal is referred to as negative amortization.
The Impact of Negative Amortization
If you intend on staying in your home indefinitely or you anticipate that your income will increase drastically after a few years, negative amortization won’t have much of an impact on you. By the time the mortgage payments increase, your income should have also increased to cover the additional cost.
But if your income doesn’t increase as expected or you decide you want to move a few years into your mortgage, negative amortization can be a problem. Basically, too much negative amortization can mean you are “upside down” on your mortgage. This means you actually owe more for your home than the actual value. Here’s an example:
Option 1: Conventional 15-year loan for $100,000 at 5% interest. Payments of $790.79 a month would mean $416.67 goes toward the interest and the balance toward the principal. After the first year, the principal amount would have decreased to $95,406.15. That’s not a huge decrease, but it still counts as paying down the mortgage.
Option 2: GPM. Let’s say you want a 15-year, $100,000 mortgage but can only comfortably afford to pay $500 a month. With a GPM, a lender might agree to those terms, but you’ll most likely pay a higher interest rate (let’s say 6.5%). Interest on the loan is $541.67. Because you’re only paying $500 a month, the remaining interest balance of $41.47 gets tacked onto the principal. This is negative amortization because now, instead of owing $100,000, you owe $100,041.67. By the end of the first year of the mortgage, you’ll owe $100,515.18. The negative amortization will continue until you start making payments that are greater than the interest amount.
If you wanted to refinance your home because it needs repairs or you want to renovate the kitchen, being upside down on your mortgage could put that idea in jeopardy. Along with lacking any significant amount of equity to tap, lenders could see the increase in principal as a red flag that you can barely make your current payments (even if you are enrolled in a special mortgage program like a GPM or payment-option ARM).
It could also hamper your ability to sell your home. In order to walk away in the clear, you would need to sell the home for what you currently owe on it, which could mean an inflated home price. Buyers usually can’t manage to purchase an underwater home because the appraisal will show a much lower value than what the lender requires to make their mortgage.
Property Value Problem
Even if you don’t anticipate needing to make changes to your home and aren’t planning to move, negative amortization can still have a negative impact on your life. If you borrowed $100,000 three years ago, because of negative amortization you might currently owe $120,000. Even if your local property values remain flat, you are still underwater with your mortgage. This means you owe more on the property than it is worth.
Again, this isn’t a big issue for people who don’t intend to sell in the foreseeable future, but if your local real estate values don’t rise enough to cover the payment portion you’re not making, it could make getting a loan for improvements impossible. And if you can’t renovate the home, then its value cannot increase beyond natural inflation. So long as you’re still upside down on your mortgage, you will become increasingly underwater as the problem compounds.
How to Lessen the Cost of Negative Amortization
If waiting until you can manage a traditional mortgage means you’d have to pass on your dream home, then there are some things you can do to help lessen the issues you could face with a specialty loan.
Make extra payments. If you get a bonus at work or you happen on an extra $100 or so, throw it toward your mortgage. Every little bit helps, and even an extra $50 to $100 added onto what you’re required to pay can decrease the amount of negative amortization you accumulate.
Try to put down a larger down payment. Even though you might only be required to make a 5% down payment, if you can afford 6 or 7%, do it. The less you have to borrow, the less you’ll have to pay back, including interest.
Keep the mortgage current. This is a given regardless of the type of loan you have, but for specialty loans, there’s an added benefit. Specialty mortgages generally require more costly mortgage insurance (MI) because of the greater risk the mortgage represents.
MI is basically an insurance policy a lender takes out on the loan. In the event that a borrower defaults, MI guarantees that the lender will at least recoup some of the money borrowed. If your payments are current, once you’ve started building equity that exceeds 20% of the loan amount you can have the MI removed (except on FHA-type loans with less than 10% down). It’ll save you a bundle every month and also means less money will be rolled back into your loan if you’re paying less than a full interest and principal payment.
Negatively amortizing mortgages are risky products, but they have their place in the real estate world. If you anticipate your income increasing in the five to ten years following your purchase, it may be best to buy now, before property values increase more. On the other hand, if you can wait to use a more traditional product, that can save a lot of headaches down the road. After all, a fixed-rate mortgage is kind of a “set it and forget it” type of loan.
The Risks of Negative Amortization
While negative amortization loans have the benefit of reducing your payments in the short run, they do have risks. Negative amortization increases the principal of your loan, and you’ll eventually have to pay all of that back (with interest, of course.)
Negative amortization can be even riskier if it’s followed by a steep decline in the value of your home. This makes it far easier to “go underwater” on your mortgage -- meaning that you currently owe more than the home is worth.
For example, imagine you owed $180,000 on a home worth $200,000. Due to negative amortization, you now owe $190,000. Next, the value of your home drops to $185,000, meaning you’d be $5,000 underwater on your mortgage. Being underwater makes it particularly hard to get your home refinanced in order to reduce your mortgage payments, and, if you fall behind, you could default on your home loan.
That’s why it’s always essential to approach any kind of negatively amortizing loan with a lot of caution -- and to only take one on when you fully understand the risks and benefits of this kind of financial arrangement.
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