Negative amortization: How does it work and how can I avoid it?

A negative amortization loan has a very small monthly payment, but it can lead to a balloon payment or more overall debt for the borrower.



Elissa Suh

Elissa Suh

Senior Editor & Disability Insurance Expert

Elissa Suh is a disability insurance expert and a former senior editor at Policygenius, where she also covered wills, trusts, and advance planning. Her work has appeared in MarketWatch, CNBC, PBS, Inverse, The Philadelphia Inquirer, and more.

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Key takeaways

  • Negative amortization happens when your loan payment does not cover the interest

  • You can avoid negative amortization by making sure you cover at least the interest with your loan payment

  • Borrowers are less likely to encounter a negative amortization mortgage since the 2008 mortgage crisis

  • Unsubsidized student loans, which defer interest, are the most common example of a negatively amortizing loan

When most people take out a loan, they expect to make regular monthly payments to the lender, and eventually after a certain period of time, the loan will be paid off. This process is called amortization — you pay down some of the principal balance and interest with every payment. But a loan can also negatively amortize, which means you're not paying down the principal amount. Negative amortization happens when you make too small of a payment, which doesn’t cover the interest, and as a result it gets added to the unpaid loan balance. Ultimately, you end up with more debt. This happens as a natural consequence of not being able to pay your loan.

The best way to avoid negative amortization is to make sure you cover at least all of the accrued interest with every payment. The longer you put off paying interest, the longer the loan will negatively amortize, and the more money you’ll owe at the end of the loan term. Many loan products and lenders even require a minimum payment that is supposed to cover the interest and prevent negative amortization from happening.

However, some loans do feature negative amortization, like unsubsidized student loans and particular types of mortgages in some states — many risky mortgage features, including negative amortization, have been banned or limited since the 2008 housing crisis.

Negative amortization loans can be financially risky, since the borrower ends up paying a huge amount of interest over the course of the loan and may even have a dramatically large payment at the end of the loan term. We'll discuss how negative amortization works and different loan examples.

A refresher on amortization

Before we talk about negative amortization, it’s good to understand amortization. Amortization is the process of paying off your loan with regular payments, consisting of both principal (how much you took out) and the interest (lenders don’t let you borrow money for free, afterall). With a fully amortizing loan, the amount you owe will decrease with every payment that you make.

For example, if you have a 30-year fixed-rate mortgage, the lender will provide you with an amortization schedule that shows all your payments during the loan term. After 30 years of regular payments, your loan will be paid.

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How does a negative amortization loan work?

With negative amortization, you end up owing more money than the original loan amount. This is a rundown of how it works:

  1. You take out a loan, which accrues interest.

  2. You make a very small monthly payment, which doesn’t cover the accrued interest (or you don’t make a payment at all)

  3. The interest capitalizes. Capitalization means the unpaid interest gets added to the principal balance, and then you have to pay interest on that.

  4. As a result, your new loan balance is higher than what you initially borrowed.

Depending on the type of loan you have, somewhere down the line, your payment may be reassessed according to the terms in your loan document (this might be after a certain number of years or monthly payments). The new payment can increase drastically, giving the borrower payment shock. If at the end of the loan term, you have a large principal balance remaining, you may even have to repay it in its entirety, which is called making a balloon payment.

Negative amortization loans may be helpful for borrowers who want to make very low payments in the beginning and expect a large influx of cash or higher income in the future. However, if you aren’t financially prepared, a negatively amortizing loan could leave you with even more debt.

Negative amortization can happen to borrowers who aren’t on top of their debt. It’s a natural result when you don’t pay at least the interest. Negative amortization could also happen on purpose because of the way a loan is structured, as with student loans, or a mortgage (we’ll talk about both in-depth next). However, ever since the mortgage crisis of 2008, there are now regulations and lending practices that ban or limit balloon payments and loan repayment terms that would allow negative amortization to happen.

Examples of negative amortization loans

One simple way to illustrate how negative amortization works is with credit card debt. If you have a credit card, you have probably noticed that there's a required minimum payment each month. If you were to pay less than the minimum payment, or don’t pay it at all, then your balance will accrue interest. Interest gets added to what you owe, and then you pay interest on that interest. Soon the total balance of your debt will be more than what you originally owed. That’s why many credit card lenders institute minimum payment requirements, to offset the possibility of the loan amortization negatively, which leads to more debt for the borrower.

The most common example of negatively amortizing loan is a student loan, specifically an unsubsidized student loan. With this type of loan, the borrower doesn’t have to pay the interest while enrolled in school; the interest is deferred. Repayments are not required until after graduation. In the meantime, the deferred interest will accrue and capitalize, which means a loan disbursed freshman year could accrue for the four years you’re in school, after which the total amount of debt will be much higher than what was initially borrowed.

Learn more about unsubsidized student loans.

What is a negative amortization mortgage?

With a graduated payment mortgage, the required payment starts small and increases according to a fixed schedule. Negative amortization may occur with these mortgage loans at the beginning, but is made up for over the loan term as the monthly payment increases. (This is similar to a student loan with a graduated repayment plan.)

Negatively amortizing mortgages are like balloon mortgages, which leave the borrower with a very large payment at the end of the loan term. (Balloon mortgages are not qualified mortgages, which follow certain standards and do not have risky features, and may be harder to find from a conventional lender.) That’s because you may need to pay a large amount of capitalized interest at the end of the term.

Certain adjustable-rate mortgages, called payment-option ARMs, are one of the few mortgage products on the market that do allow for negative amortization. With a payment-option ARM, the borrower can choose to make a monthly mortgage payment that does not cover the interest. This can increase the remaining principal balance and result in negative equity.

A reverse mortgage allows senior homeowners to take out a loan against the value of their house while continuing to live in the home. The borrower does not need to start making a reverse mortgage payment immediately; the mortgage loan may not even be repaid until after the borrower moves away or dies, but it will accrue interest during this time, which means it will negatively amortize. There are many government regulations in place, including caps on how much you can owe.

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