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Negative Amortization

Negative amortization, also referred to as NegAm, is used to describe an instance when the balance on a loan continues to increase instead of decrease every month, with each payment that is made. The reason that this occurs is that the payment made at each period is less than the amount that is required to cover to sum of the interest.

If this is the case, the amount that therefore remains in interest, which is called the unpaid interest, is then added to the existing loan balance, so that the final amount to be repaid becomes larger than the original amount. It is also called deferred interest or Graduated Payment Mortgage. This method is generally used in an introductory period before loan payments exceed interest and the loan becomes self-amortizing. It is most commonly used for mortgage loans and corporate loans that have negative amortizations, which are called PIK loans.

Negative amortization loans are most commonly seen as home loans, and the aim is to reduce the monthly payments during the beginning of the loan so that the loan becomes easier for the client to repay later on. Eventually, the payments are usually adjusted so that they can manage to pay off a large part of the principal balance. Negative amortization loans are sometimes paired up with ‘balloon payment’ so as to achieve this result.

The practice of negative amortization loans needs to be agreed upon between parties before giving out the loan and starting the payment in order to prevent default on payment. Negative amortization loans have a recast period. This is typically sixty months, which is a period of five years. The negative amortization limit is most commonly up to a twenty five percent increase of the loan balance over the principal amount. This balance cap is determined by State and Federal legislation.

There are quite a few risks that need to be thoroughly investigated before taking a negative amortization loan. The most important one is that there will inevitably be a point at which the payments made periodically will be increased in order to ensure that the loan can eventually be repaid.

The time that most people ask for negative amortization loans is when they predict the value of a particular asset will continue to increase significantly. This means that they can therefore potentially be able to refinance that asset for a higher amount and at a higher interest rate by paying off the initial loan, before getting a new loan that has terms that are more suited. But the issue with this strategy is that if, by chance, the value of the item in question remains stable, or decreases, refinancing is no longer an option. If the decrease in value of the particular item is significantly steep, then the increase that will result in the monthly payments can be quite problematic.

Most financial advisers tend to have mixed feelings and suggestions such negative amortization loans. Those who take these kinds of loans should be aware of what it entails and need to ask exactly how much will be required as payment over the duration of the loan.

Tags: finance, loan, mortgage, risk

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