Negative Amortization

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Mortgages are intended to be amortized over the loan period. In other words, throughout the duration of the loan period, the amount of money borrowed (the principal) is gradually reduced by the regular repayments until the last payment is made and the loan is paid off. However, in certain circumstances the mortgage is structured so that instead of regular amortization occurring and the principal getting reduced, the principal actually increases so that the amount owed to the lender gets larger. This is known as negative amortization. For most borrowers an increasing principal would seem like a nightmare, but for some borrowers it is a risk they are prepared to run. It typically occurs when an option mortgage is taken out. This type of mortgage gives the mortgagee various repayment options, one of which might be to pay only interest, and for an amount that does not fulfill the requirements to pay off the loan within the prescribed loan period. In other words, an adequate repayment might be $500 a month, but the borrower elects to pay only $400. What happens then is that under the terms of the mortgage the remaining $100 is added back on to the principal amount. It could therefore be known as an "increasing principal" mortgage, but is called negative amortization. For some people it is not a bad alternative; such people typically have sufficient but erratic annual earnings, or expect to shortly sell the house at a profit. In the meantime they have kept their repayments to an absolute minimum. But negative amortization can be devastating if house prices fall and the mortgage interest rate increases (because option mortgages are usually adjustable rate mortgages) and so the owner must sell because he is unable to afford the increased payments. He is faced with getting less from the sale than the amount of principal he owes and so must contribute his own money to pay off the lender: negative amortization has now become negative equity. See also Interest-Only Mortgage and Option Mortgage.