Question

Explain negative amortization and how such a situation can occur.

D) In creating a plan to buy your life insurance, what factors should you consider before buying? Also, describe from whom you should buy, including the sources.

Answer 1

Amortization means paying off a loan with regular payments, so that the amount you owe goes down with each payment. Negative amortization means that even when you pay, the amount you owe will still go up because you are not paying enough to cover the interest.

Your lender may offer you the choice to make a minimum payment that doesn’t cover the interest you owe. The unpaid interest gets added to the amount you borrowed, and the amount you owe increases.

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.