Negative amortization
In finance, negative amortization occurs whenever the loan payment for any period is less than the interest charged over that period so that the outstanding balance of the loan increases. As an amortization method the shorted amount is then added to the total amount owed to the lender. Such a practice would have to be agreed upon before shorting the payment so as to avoid default on payment. This method is generally used in an introductory period before loan payments exceed interest and the loan becomes self-amortizing. The term is most often used for mortgage loans; corporate loans with negative amortization are called PIK loans.
Amortization refers to the process of paying off a debt through regular payments. A portion of each payment is for interest while the remaining amount is applied towards the principal balance. The percentage of interest versus principal in each payment is determined in an amortization schedule.
Defining characteristics
Negative amortization only occurs in loans in which the periodic payment does not cover the amount of interest due for that loan period. The unpaid accrued interest is then capitalized monthly into the outstanding principal balance. The result of this is that the loan balance increases by the amount of the unpaid interest on a monthly basis. The purpose of such a feature is most often for advanced cash management and/or more simply payment flexibility, but not to increase overall affordability.Neg-Ams also have what is called a recast period, and the recast principal balance cap is in the U.S. based on federal and state legislation. The recast period is usually 60 months. The recast principal balance cap is usually up to a 25% increase of the amortized loan balance over the original loan amount. States and lenders can offer products with lesser recast periods and principal balance caps; but cannot issue loans that exceed their state and federal legislated requirements under penalty of law.
A newer loan option has been introduced which allows for a 40-year loan term. This makes the minimum payment even lower than a comparable 30-year term.
Special cases
- Reverse mortgage: In the extreme or limiting case of the principle of negative amortization, the borrower in a loan does not need to make payments on the loan until the loan comes due; that is, all interest is capitalized, and the original principal and all interest accrued as of the due date are paid off together and at once. The most common context in which this arrangement occurs is that of using residential single-family real estate as collateral for the loan, in which case the loan is known as a reverse mortgage. In the United States of America, the terms of reverse mortgages are heavily regulated by federal law, which as of January 2016 places a lower age limit on the set of permitted borrowers and requires that the mortgage come due only when the borrower no longer uses the property in question as his/her principal residence, usually due to the borrower's death.
Typical circumstances
All NegAM home loans eventually require full repayment of principal and interest according to the original term of the mortgage and note signed by the borrower. Most loans only allow NegAM to happen for no more than 5 years, and have terms to "Recast" the payment to a fully amortizing schedule if the borrower allows the principal balance to rise to a pre-specified amount.This loan is written often in high cost areas, because the monthly mortgage payments will be lower than any other type of financing instrument.
Negative amortization loans can be high risk loans for inexperienced investors. These loans tend to be safer in a falling rate market and riskier in a rising rate market.
Start rates on negative amortization or minimum payment option loans can be as low as 1%. This is the payment rate, not the actual interest rate. The payment rate is used to calculate the minimum payment. Other minimum payment options include 1.95% or more.
Adjustable rate feature
NegAM loans today are mostly straight adjustable rate mortgages, meaning that they are fixed for a certain period and adjust every time that period has elapsed; e.g., one month fixed, adjusting every month. The NegAm loan, like all adjustable rate mortgages, is tied to a specific financial index which is used to determine the interest rate based on the current index and the margin. Most NegAm loans today are tied to the Monthly Treasury Average, in keeping with the monthly adjustments of this loan. There are also Hybrid ARM loans in which there is a period of fixed payments for months or years, followed by an increased change cycle, such as six months fixed, then monthly adjustable.The graduated payment mortgage is a "fixed rate" NegAm loan, but since the payment increases over time, it has aspects of the ARM loan until amortizing payments are required.
The most notable differences between the traditional payment option ARM and the hybrid payment option ARM are in the start rate, also known as the "minimum payment" rate. On a Traditional Payment Option Arm, the minimum payment is based on a principal and interest calculation of 1% - 2.5% on average.
The start rate on a hybrid payment option ARM is higher, yet still extremely competitive payment wise.
On a hybrid payment option ARM, the minimum payment is derived using the "interest only" calculation of the start rate. The start rate on the hybrid payment option ARM typically is calculated by taking the fully indexed rate, then subtracting 3%, which will give you the start rate.
Example: 7.5% fully indexed rate − 3% = 4.5%
This guideline can vary among lenders.
Aliases the payment option ARM loans are known by:
- PayOption ARM
- Negative Amortizing Loan
- Pick - A - Pay
- Deferred interest option loan
Mortgage terminology
- Cap
- Life cap
- Index
- Margin
- Fully indexed rate
- Payment options
- Period
- Recast
- Stop
Criticisms
- Unlike most other adjustable-rate loans, many negative-amortization loans have been advertised with either teaser or artificial, introductory interest rates or with the minimum loan payment expressed as a percentage of the loan amount. For example, a negative-amortization loan is often advertised as featuring "1% interest", or by prominently displaying a 1% number without explaining the F.I.R. This practice has been done by large corporate lenders. This practice has been considered deceptive for two different reasons: most mortgages do not feature teaser rates, so consumers do not look out for them; and, many consumers aren't aware of the negative amortization side effect of only paying 1% of the loan amount per year. In addition, most negative amortization loans contain a clause saying that the payment may not increase more than 7.5% each year, except if the 5-year period is over or if the balance has grown by 15%. Critics say this clause is only there to deceive borrowers into thinking the payment could only jump a small amount, whereas in fact the other two conditions are more likely to occur.
- Negative-amortization loans as a class have the highest potential for what is known as payment shock. Payment shock is when the required monthly payment jumps from one month to the next, potentially becoming unaffordable. To compare various mortgages' payment-shock potential :
- * 30-year fixed-rate fully amortized mortgages: no possible payment jump.
- * 5-year adjustable-rate fully amortized mortgage: No payment jump for 5 years, then a possible payment decrease or increase based on the new interest rate.
- * A 10-year interest only mortgage product, recasting to a 20-year amortization schedule could see a payment increase of up to $600 on a balance of 330K.
- * Negative amortization mortgage: no payment jump either until 5 years OR the balance grows 15% higher than the original amount. The payment increases, by requiring a full interest-plus-principal payment. The payment could further increase due to interest-rate changes. However, all things being equal, the fully amortized payment is almost triple the negatively amortized payment.
- * First month free: a loan officer may allow the borrower to skip the first monthly payment on a refinance loan, by simply adding that payment to the principal and charging compound interest on it for many years. The borrower may not understand or question the transaction.
However, if the property values decrease, it is likely that the borrower will owe more on the property than it is worth, known colloquially in the mortgage industry as "being underwater". In this situation, if the property owner cannot make the new monthly payment, he or she may be faced with foreclosure or having to refinance with a very high loan-to-value ratio, requiring additional monthly obligations, such as mortgage insurance, and higher rates and payments due to the adversity of a high loan-to-value ratio.
It is very easy for borrowers to ignore or misunderstand the complications of this product when being presented with minimal monthly obligations that could be from one half to one third what other, more predictable, mortgage products require.