What is negative amortization ?

Negative amortization is a method in which the borrower or the recipient of the loan pays less than the full monthly payment amount on a loan. When a borrower makes a payment on a loan, part of that payment is applied towards the principal (loan balance) and the other part is the interest payment on the loan - or cost of borrowing. When a payment made by the borrower is lower than the interest amount on a monthly payment, the difference between the interest owed and the amount paid by the borrower is added to the amount owed by the borrower or to the loan balance. This increases the loan balance instead of decreasing it, as would happen in a normal fully amortizing loan where the full payment amount is made. This process hence is described as negative amortization.

Borrowers should clearly understand the terms and conditions on a loan with negative amortization. Such a feature should be stated upfront before a borrower buys the loan.
A negative amortization feature does not increase the affordability of the loan, it simply provides payment flexibility.

Loans with negative amortization, if offered by a lender, increase affordability for the borrower, but they gradually increase the debt burden for the borrower. Most loans with negative amortization have caps. These typically cap the increase in loan balance to 125% of the loan amount or don't allow negative amortization to happen more than 5 years.

Loans with negative amortization were popular a year ago when interest rates were still low and housing prices were on the rise. Most borrowers who purchased such loans were banking on the increase in their home prices to offset the increase in their loan balances. This has changed today. As the housing market continues to decline, for inexperienced investors, loans with negative amortization can spell a lot of trouble - not only does the loan balance increase, but overall equity in the house continues to fall due to decline in home prices. In such a market, both the borrowers and the lenders should be very cautious of such loans as the possibility of default rises. Because most of them are adjustable rate mortgages, when they reset, they carry a high likelihood of what is referred to as 'payment shock'. The monthly mortgage payments can jump from month to month making them potentially unaffordable for some borrowers.

In conclusion, although loans with negative amortization offer some benefits to borrowers wanting to enter the housing market, given today's condition, it would be wise to tread these waters with some caution.