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How Does Negative Amortization on a Mortgage Work?

How Does Negative Amortization on a Mortgage Work?

September 15, 1998

Negative Amortization and Related Concepts

Ordinarily, the mortgage payment you make to the lender has two parts: interest due the lender for the month, and amortization of principal. Amortization means reduction in the loan balance -- the amount you still owe the lender.

For example, the monthly mortgage payment on a level payment 30-year fixed-rate loan of $100,000 at 6% is $600. In the first month, the interest due the lender is $500, which leaves $100 for amortization. The balance at the end of month one would be $99,900.

Because a payment of $600 a month maintained over 30 years would just pay off the balance, assuming no change in the interest rate, it is said to be the fully amortizing payment. A payment less than $600 would leave a balance at the end of 30 years. A payment greater than $600 would pay off the loan before 30 years.

Suppose you made a payment of $550, for example. Then only $50 would be available to reduce the balance. Amortization would still occur, but it would be smaller and not sufficient to reduce the balance to zero over the term of the loan. $550 is a partially amortizing payment.

Next, suppose you pay only $500. Since this just covers the interest, there would be no amortization, and the balance would remain at $100,000. The monthly payment is interest-only. Back in the 1920s, interest-only loans usually ran for the term of the loan, so that the borrower owed as much at the end of the term as at the beginning. Unless the house was sold during the period, the borrower would have to refinance the loan at term.

Today, some loans are interest-only for a period of years at the beginning, but then the payment is raised to the fully-amortizing level. For example, if the loan referred to above was interest-only for the first 5 years, at the end of that period the payment would be raised to $644. This is the fully-amortizing payment when there are only 25 years left to go.

Finally, suppose that for some reason, your mortgage payment in the first month was only $400. Then there would be a shortfall in the interest payment, which would be added to the loan balance. At the end of month one you would owe $100,100. In effect, the lender has made an additional loan of $100, which is added to the amount you already owe. When the payment does not cover the interest, the resulting increase in the loan balance is negative amortization.

Purposes of Negative Amortization

Historically, the major purpose of negative amortization has been to reduce the mortgage payment at the beginning of the loan contract. It has been used for this purpose on both fixed-rate mortgages (FRMs) and adjustable rate mortgages (ARMs). A second purpose, applicable only to ARMs, has been to reduce the potential for payment shock -- a very large increase in the mortgage payment associated with an increase in the ARM interest rate.

The downside of negative amortization is that the payment must be increased later in the life of the mortgage. The larger the amount of negative amortization and the longer the period over which it occurs, the larger the increase in the payment that will be needed later on to fully amortize the loan.

Negative Amortization on Fixed-Rate Loans

On fixed-rate loans, negative amortization is a tool for reducing the mortgage payment in the early years of a loan, at the cost of raising the payment later on. Instruments that incorporate this feature are called graduated payment mortgages or GPMs. There are many possible GPMs that differ in terms of the size of the payment increase and the number of years over which increases occur. The following is a small sampling of 6% 30-year GPMs compared to the standard level-payment mortgage described above, and to FRMs that are interest-only for varying periods.




GPMs, Interest-Only FRMs, and Standard FRMs, at 6% for 30 Years

Type of Loan

Initial Payment

Highest Payment

Month Highest Payment Reached

Highest Balance

Month Highest Balance Reached

Standard Level Payment






Graduated Payment:          

7.5% for 5 Years






5% for 10 Years






7.5% for 10 Years






Interest Only:          

For 10 Years






For 15 Years






For 20 Years






The first GPM calls for annual increases in the mortgage payment of 7.5% for 5 years. The initial payment is $445 as compared to $600 on the standard mortgage, but the GPM payment rises to $639 in the sixth year where it remains for the balance of the term. Negative amortization is modest, the balance rising to $100,989 in month 24 before positive amortization begins. The other GPMs have even lower initial payments but the ultimate payments are higher and negative amortization is greater.

In general, the lower the initial payment on a GPM and the smaller the payment increases, the larger the negative amortization and the final payment. However, the final payment can be higher on an interest-only FRM than on a GPM, depending on how long the interest-only period is.

GPMs make sense for borrowers who can confidently predict that their incomes will rise over time to at least keep pace with the rising payment. A drawback is that if they sell their house after only a few years, they will owe the lender more than when they began. A more serious drawback is that some borrowers with questionable prospects for the future nevertheless elect GPMs because it is the only way they can qualify for the loans they want.

Historically, default rates on GPMs in the US have been higher than on standard level-payment loans, and lenders have become reluctant to make them as a result. In the relatively low-interest rate environment of recent years, GPMs are less needed to get the payments down to affordable levels, and they have virtually died out.

Interest-only FRMs are around but they are used mainly for high net worth individuals with variable incomes who expect to prepay much of the loan balance before the end of the interest-only period.

Negative Amortization and Payment Shock on Graduated Payment Adjustable Rate Mortgages

In the high-interest rate environment of the early 80s, negative amortization on some adjustable rate mortgages (ARMs) served the same purpose as on GPMs � allowing reduced payments in the early years of the loan. Payments in the early years of these "GPARMs" were deliberately set lower than the interest due the lender, resulting in negative amortization. As with GPMs, the amount of this negative amortization was known in advance.

If interest rates on GPARMs rose from their initial levels, however, it could result in additional negative amortization that was not known in advance. This in turn could result in payment shock. These instruments experienced default rates even higher than those on GPMs, and they soon stopped being offered in the marketplace.

ARMs in the Late 90s Without Negative Amortization

Most ARMs today do not have the potential for negative amortization. Whenever the interest rate is changed, the mortgage payment is adjusted immediately so that it will continue to amortize the loan fully over the portion of the original term that remains. On such ARMs, the mortgage payment is always "fully amortizing".

Payment shock on ARMs that always have fully amortizing payments is avoided by capping the size of any interest rate increase. On ARMs that adjust the rate every 6 months, the cap is usually 1%, and on ARMs that adjust the rate every year the cap is usually 2%. However, on ARMs where the initial rate holds for 5, 7 or 10 years and then adjusts annually, the cap at the first rate adjustment is usually 5%, dropping to 2% on subsequent (annual) adjustments.

The affordability of ARMs today is enhanced not by a graduation feature but by relatively low initial rates. In general, the shorter the period for which the initial rate holds, the lower the initial rate.

ARMs in the Late 90s With Negative Amortization

The most important remaining ARM with the potential for negative amortization is the monthly adjustable -- the interest rate is adjusted every month and there is no interest rate adjustment cap. If the mortgage payments on such loans were always fully amortizing, borrowers would be vulnerable to extreme payment shock. For example, a monthly adjustable I looked at on Feb. 27, 1998 had an initial interest rate of 7.75% and a maximum rate of 12%. If markets rates exploded the month after this loan was closed, the rate would rise to 12% and the new fully amortizing payment would be 71% higher.

To avoid this possibility, these loans adjust the payment only once a year subject to a payment adjustment cap of 7.5%. In the event of an interest rate explosion, the rate would go to 12%, but instead of a one-time jump in payment of 71%, the adjustment would be stretched out to annual changes of 7.5% over 6 years. But the consequence of stretching out the payment adjustment is negative amortization. For 5 years the payment would fail to cover the interest and the balance would rise to 109% of its original value before it started to come down.

All other things equal, caps on interest rate adjustments are much better for the borrower than caps on payment adjustments that can result in negative amortization. The problem is that other things are seldom equal. The monthly adjustable described above adds a smaller markup ("margin") to the rate index than ARMs with rate adjustment caps, and is tied to an interest rate index that has a lower value.

The bottom line is that it doesn't make sense to assess ARMs in terms of whether or not they permit negative amortization. What matters in the decision process is how the ARMs would perform in different future rate environments. On Feb. 27, 1998 when I looked at this, a monthly adjustable would perform better in a stable or declining rate environment, but worse in a rising rate environment, than other ARMs that have rate adjustment caps. However, the advantage of the monthly adjustable in a stable rate environment was small while the disadvantage in a rising rate environment was uncomfortably large -- for me. I would avoid the monthly adjustable, but someone else might feel differently.

Copyright Jack Guttentag 2002


Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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