Definition:
Negative amortization happens when a borrower’s monthly mortgage payment is less than the interest due on the loan, causing the unpaid interest to be added to the loan balance. Over time, this increases the total amount owed instead of reducing it.
Example:
Lena has a loan with a low initial payment, and she chooses to pay only $900 each month, even though $1,200 in interest is due. The extra $300 gets added to her loan balance, so she ends up owing more than she originally borrowed—this is negative amortization.
Explanation:
Most mortgages are amortized, meaning each monthly payment includes both interest and a portion of the principal, gradually paying off the loan. In a negative amortization loan, the borrower’s payments don’t cover the full interest amount due. The unpaid interest gets added to the loan principal, causing the balance to grow instead of shrink.
These types of loans often come with option ARMs (adjustable-rate mortgages) or other flexible-payment loans that allow borrowers to:
- Make a minimum payment
- Pay only interest
- Pay full principal and interest
- Pay extra toward the loan
While the flexibility can be attractive—especially in the short term—it can lead to payment shock later when the loan resets and higher payments are required to repay the growing balance.
Why is Negative Amortization Important in Real Estate Transactions?
Negative amortization is important because it can significantly affect a borrower’s financial health over time. For homebuyers, it’s critical to understand how payments impact loan balance and future affordability. For sellers and real estate professionals, educating buyers about the risks can help prevent foreclosures and promote sustainable homeownership. Loans with negative amortization should be approached with caution and a clear long-term plan.