Negative Amortization

What is negative amortization?

Negative amortization is used to describe loans that have payment adjustment caps instead of interest rate adjustment caps. Most loans are designed to amortize, i.e. reduce, to a zero balance by the end of their loan term. Therefore each payment contains a portion of interest (primarily interest at the beginning) and a portion of principal. These loans are referred to as "no negs" or not having the possibility for negative amortization. Generally, E-Loan recommends these loans over negative amortization products because of the risks of having the loan principal increase instead of decreasing.

How does negative amortization occur?

Negative amortization loans calculate two interest rates. The first is called the payment rate the second is the actual interest rate. The payment rate is typically capped at 7.5% of the previous payment. The true interest rate is calculated as simply the index plus the margin without periodic caps. Borrowers are given a choice of which rate to pay. Thus advertisers of negative amortization loans often refer to these loans as "payment option" loans. While it is true that the borrower has a payment option, which offers flexibility, the borrower will also be subject to the true interest rate.

Risk Considerations

The risk associated with a negative amortization product is that the interest rate calculation does not have a periodic cap and therefore can increase to the lifetime cap at any time. This is fundamentally different from "no negs" which always have periodic caps. Therefore, in terms of wealth generation, negative amortization loans are more risky and often not as good an investment as "no negs".

When to Consider a Negative Amortization Product

Negative amortization loans can be useful if the borrower is primarily concerned with cash flow rather than equity. If the borrower only pays the payment rate, the overall mortgage payment over time can be relatively low. This type of product can be a temporary strategy if income is expected to be reduced for a period of time, or if the hold period is short term to minimize cash outflow.

Nevertheless, one of the main reasons for purchasing a home is to build equity and generate greater wealth. If a borrower is primarily concerned with cash flow, a better strategy could be to simply rent rather than own.