Question

Explain negative amortization and how such a situation can occur. explain in atleast 300 words.

Answer 1

What is Negative Amortization?

Negative amortization occurs when the principal amount on a loan increases gradually because the loan repayments do not cover the total amount of interest costs for the period. It occurs because borrowers are allowed to make reduced payments for a certain period within the term of the loan. Therefore, the payments received are used to pay the accruing interest on the loan, and the balance of the unpaid interest costs is added to the principal amount.

Eventually, such an arrangement can lead to large loan payments in the future. Once the period of reduced loan payments elapses, the borrower makes regular payments to settle the outstanding balance on the loan.

For example, if a borrower took a $1,000 loan from a bank and repaid only $950, then the balance of $50 is added to the principal balance of the loan. Such an arrangement is common in certain types of loans, such as mortgages, student loans, and credit card loans.

When Negative Amortization is Used

The following are the two main ways in which negative amortization is used by borrowers:

1. The borrower is unable to pay

Negative amortization may be used when the borrower lacks enough funds to make the required monthly loan repayments. For example, when a borrower is unemployed and is unable to continue repaying a loan, they can apply for deferment, which allows them to temporarily stop making loan payments.

However, the interest costs continue to accrue, and they are added to the balance of the principal amount. It increases the principal amount, and the borrower will be responsible for paying the accumulated principal and interest costs when they resume making the regular loan repayments.

2. The borrower pays less than the monthly interest costs

When the borrower pays less than the required interest costs for the month, there is a portion of the interest cost that remains unpaid. Since the borrower is unable to cover the full interest costs, it means that there is an interest amount due to the lender at the end of each period.

The lender adds the unpaid interest charge to the loan balance, and the outstanding loan balance keeps growing every month. Eventually, the borrower will need to pay off the loan balance by making a lump sum payment to pay off the entire debt or by making regular amortizing payments that are higher than the monthly installments in the original loan agreement.

Negative Amortization Process

Amortization is a standard process where a borrower pays off a loan with regular loan payments so that the outstanding balance goes down with each payment received. For example, when a borrower takes a 30-year fixed-rate mortgage, they are required to pay the same regular payments every month even as the principal and interest balance decrease over time.

If the mortgage requires an $800 monthly payment over 30 years, the loan is said to be fully amortized, assuming there is no change in the interest rate. If the borrower makes a payment that is higher than the $800 monthly payment, it means that the loan will be cleared before the 30 years elapse. Similarly, a reduced monthly payment of less than $800 would stretch the loan beyond 30 years.

Negative amortization is the inverse of standard amortization because the principal amount on the loan increases when the borrower makes small payments or fails to make any payments. It means that, as the borrower makes smaller payments, the outstanding principal amount will increase since the payments are insufficient to cover the interest costs.

Usually, the lender may offer the borrower the option of making a minimum payment that does not cover the interest cost. The interest cost due is added to the principal amount, and it increases the outstanding loan balance. Eventually, after a certain period, the borrower will be required to start making regular payments to cover both the principal and interest costs. It means that the payments may be higher than the standard monthly payments, and the borrower may end up paying more on the mortgage than the home is actually worth.

Practical Example

Assume that John took a 30-year mortgage with a 7.5% annual interest rate, and the outstanding principal balance is $100,000. The loan agreement allows John to make $500 monthly payments for a certain period during the 30-year period. In the next scheduled repayment, John is required to pay the regular $625 (0.075/12 x 100,000) interest costs.

However, due to financial constraints, he opts to pay the $500 interest cost allowed in the loan agreement. It means that the interest due is $125 ($625 – $500), which is added to the principal balance.

The interest due is added to the principal balance to bring the new balance to $100,125. In the next repayment period, the interest cost will be calculated based on the increased principal amount.